Can Europe Evolve?

The Trump administration’s trade policies and attitudes toward NATO and Ukraine have caused significant discontent and disbelief in European capitals. But many European policymakers see a silver lining as well: At long last, the continent appears to be rethinking its self-defense and fiscal institutions. Europe’s ability to defend itself has atrophied for a generation, while the European Union’s system of fiscal federalism is outdated if it was ever appropriate.

Let’s start with European fiscal federalism. The population and economy of the European Union are similar in size to those of the United States, but the balance the United States and Europe strike between central and decentralized fiscal capacity is very different. While the 2019 EU budget was about 1 percent of EU-wide gross domestic product (GDP), overall public-sector expenditures amounted to 49 percent of the EU’s output. Most of the EU’s revenue, some 70 percent, comes from contributions based on gross national income from the member states as opposed to continent-wide tax instruments. In contrast, the 2024 US federal budget was approximately 23 percent of GDP, or 20 times the EU budget as a share of output, financed overwhelmingly with revenue from taxes levied by the federal government itself. In contrast, overall US public-sector expenditures were significantly lower than European expenditures, at about 37 percent of GDP.

These numbers reflect the starkly different choices Europe and the US have made in managing the problems that can arise in a fiscal and currency union. While those choices reflect differences in political culture and historical context, the problems they are meant to address are fundamentally the same.

The first problem is that a member state—a country in the EU or a US state—may engage in such irresponsible budgetary practices or be hit by such a large negative shock that it requires a bailout. To forestall this, 49 of 50 US states have balanced-budget requirements on the books, and all 50 typically balance their budget. The adoption of balanced-budget requirements was, in large part, a reaction to widespread subnational profligacy in the 1820s and 1830s. Rapid growth in borrowing in the run-up to the Panic of 1837 culminated in Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, Pennsylvania, and the Florida Territory defaulting on their debt during the subsequent depression. In the EU, member states have similarly agreed to budgetary discipline through various restrictions on their deficit and debt levels laid out in the Stability and Growth Pact, adopted in the late 1990s as most EU member states prepared to form a currency union.

Problem solved, one may think, except that these constraints, if they work, generate pro-cyclical fiscal policy. Economic downturns reduce revenues. To ensure budgets remain more or less balanced, states have to cut their spending just when that is least appropriate from a macroeconomic perspective. The American system of fiscal federalism addresses this with a heavy reliance on the federal government in general and for countercyclical economic policy in particular. This system developed gradually over the almost two centuries following the state defaults, in tandem with the expansion of the size of government to the dominant role it plays today.

The main hurdle keeping the European Union from moving toward a system with greater central fiscal authority is that such centralization tends to overtly or covertly entail fiscal transfers, typically from rich to poor member states.

While Europe’s system of decentralized fiscal authority allows for the coexistence of wildly different national systems of redistribution, social insurance, and corporate taxation, it struggles to deliver the same kind of business cycle management. Member states bear this responsibility even though they have only limited latitude to engage in countercyclical fiscal policy, even if they have the capacity to do so. This has been a major obstacle to sound macroeconomic policy for almost the entire existence of the European currency union. Partly driven by this inadequate set of macro policies, real disposable income per capita has grown almost twice as fast in the US as in the EU since the start of the currency union.

The main hurdle keeping the European Union from moving toward a system with greater central fiscal authority is that such centralization tends to overtly or covertly entail fiscal transfers, typically from rich to poor member states. This highlights the third problem that may arise in a fiscal union: While expanded central fiscal authority can help with business cycle management, it creates a powerful incentive for each constituent state to free ride on the contributions of other states. At the margin, the benefits from expansions of the central authority will tend to be concentrated (e.g., the citizens of a particular state), while costs are widely diffused. Each state’s share of the central authority’s finances will depend on its share of EU-wide national income, which for most states is close to zero and in all cases is far from one. These incentives push relentlessly toward a bloated central authority and, when mismanaged, to unsustainable debt dynamics.

This trio of problems creates what one might call a fiscal federalism trilemma. It is difficult, if not impossible, to avoid bailouts of insolvent members, wild regional fluctuations, and central government bloat all at the same time.

So far, the European Union has chosen to suffer the consequences of pro-cyclical fiscal policy, as well as the occasional bailout. The US has chosen to concentrate fiscal capacity at the federal level, which has led to much more revenue and spending at that level than we observe in the EU. Unsurprisingly, given the potential for free riding, it has also led to frequent and increasingly large budget deficits, as well as a debt trajectory that appears to be out of control. The growth of Medicaid, which provides health insurance for the economically disadvantaged and is jointly financed by the state and federal governments, is illustrative; the federal share of Medicaid expanded from one-quarter of 1 percent to 2.1 percent of GDP from 1970 to 2023—double the size of the EU’s budget. So too is the evolution of ad hoc fiscal aid (specifically, aid from the federal to the state and local governments) to counter crises; such aid was modest following the collapse of the late 1990s dot-com bubble, approached $250 billion during the global financial crisis, and neared $1 trillion during the COVID-19 pandemic.

For the past few years, Europe has been reconsidering its approach to the fiscal federalism trilemma. EU member states deemed the COVID-19 pandemic to be exceptional enough that debt and deficit restrictions should be waived entirely in 2020 and 2021 through activation of the so-called general escape clause. This gave member states the legal means to engage in aggressive countercyclical fiscal efforts. It did not (and indeed could not), however, remove the limitations on their fiscal space that result from the risk of escalating interest rates. This was of particular concern to member states that entered the crisis with high debt burdens or faced lender skepticism during recent European debt crises.

To address this concern, the EU set up the €750 billion NextGenerationEU (NGEU) facility, among other measures. NGEU provided intergovernmental grants and loans to member states, especially those with limited fiscal capacity and severe disease burdens. Financed with centralized, EU-level bonds, NGEU effectively doubled the size of the EU’s central fiscal authority for a number of years. Where NGEU provided grants, repayment is the responsibility of the EU, which will rely on its own resources. Where it provided loans, repayment is the responsibility of the member states, though it is ultimately guaranteed by the central fisc as well. The latter structure, of back-to-back loans, was also followed in the Support to Mitigate Unemployment Risks in an Emergency (SURE) program, which provided about €100 billion in central funding to backstop national unemployment insurance programs. The EU’s role in backstopping unemployment benefits can be analogized to the US federal government’s long-standing role as a financer of extensions to states’ standard benefits during times of high unemployment.

To return to the broader comparison with the US, federal, noninterest spending did not consistently exceed 2 percent of GDP until the 1910s. Observers frequently referred to the establishment of the NGEU as Europe’s Hamiltonian moment of federal debt consolidation, harkening back to the 1790s. But it is better to think of Europe’s ongoing tinkering with fiscal rules and federalized spending in reference to the lengthy process the US has undergone over the nearly two centuries since 1837.

Was the centralized fiscal capacity of NGEU the first step in a transition process toward something resembling the American system of fiscal federalism? Time will tell. At a minimum, however, it illustrates the limitations of relying entirely on decentralized countercyclical fiscal policy.

Europe needs significant additional defense spending, and it needs significant additional defense production capacity.

When US noninterest spending did exceed 2 percent of GDP before the 1910s, it was typically during wartime. It is now a time of war in (parts of) Europe. With the Trump administration leaving Ukraine to its fate and the future of NATO in question, European policymakers have become distrustful of America’s security guarantee. There have been ebbs and flows of grumblings about European “strategic autonomy” since President Emmanuel Macron’s 2017 Sorbonne speech, but that push has gained some real momentum these past few months.

What needs to happen for a meaningful military buildup in Europe has long been clear. Europe needs significant additional defense spending, and it needs significant additional defense production capacity. The latter will not materialize without the former, and the former will not materialize without Germany and its one-fourth of the EU’s economic activity. Though the term Zeitenwende has been thrown around before, Germany at long last appears to be moving.

During a postelection debate in late February, incoming German Chancellor Friedrich Merz announced that his “absolute priority will be to strengthen Europe as quickly as possible so that, step by step, we can really achieve independence from the USA.” So far, he is delivering on that to a surprising extent. The outgoing Bundestag amended the fiscal rule in the German constitution to accommodate significant additional defense (and climate and infrastructure) spending.

At the European level, there appears to be agreement to loosen fiscal constraints to facilitate the defense buildup, mimicking to some extent the emergency measures implemented in response to the COVID-19 pandemic. The first key measure is activation of the national escape clause of the Stability and Growth Pact, which allows for renewable one-year deviations from pact-compliant fiscal paths by member states that have additional fiscal space for defense spending and are willing to use it. In addition, the European Commission will provide “federal” funding. It will do so by letting countries spend existing European funds more flexibly and, more importantly, by setting up a new instrument—structured like the pandemic-era NGEU loans and the SURE program—to provide €150 billion in loans to member states.

If these and other similar programs do, in fact, usher in a more American-style approach to fiscal federalism, the demands of the trilemma will shift. The EU’s levers for managing recessions and other crises will be expanded and the associated benefits easier to obtain. But the incentive to ratchet toward less sound fiscal trajectories will similarly become more difficult to resist. Resisting such pressures will be important, as the size of the EU’s member governments mean the EU’s central authority would embark on its growth path with far less fiscal space than its American counterpart. The key question, then, is whether the EU can create such a central authority that proves effective while meaningfully constrained in size and scope.