Funding the European Air Defense with debt from the European Union.

Experience in Ukraine and Israel shows that effective missile defense is feasible. It is also expensive. The high cost of air-defense systems such as the US-made Patriot or the German IRIS-T is one reason why European governments have invested insufficiently. A single Patriot missile battery costs around $1 billion and the build-up of a European air defense shield could easily amount to an investment in the hundreds of billions.

European Commission President Ursula von der Leyen has said she intends to build a “European defense fund” and to propose “defense projects of common European interest starting with a European air shield”. However, it is unclear, how such an air shield would be funded.

Major upfront investments are difficult to fund from regular national budgets. Moreover, national and European budget rules, plus limited fiscal space, make it difficult for some European countries to borrow to fund expensive air defense equipment. Finally, if countries do it alone, they might invest insufficiently, neglecting the public good they are providing.

The fiscal rules that govern European Union countries could be sidestepped by issuing on an exceptional basis EU debt that would provide resources for this costly air-defense roll-out. This act of mutual assistance would free national budgetary resources and provide long-term funding stability, while also boosting the domestic defense industry.

But such EU debt would have to be justified in EU law and implemented. In this Policy Brief, we propose the creation of an EU funding mechanism to internalize the positive externalities provided by national air-defense systems, whether in the context of the “drone wall , protection against air raids and cruise missiles or threats from ballistic missiles. Command-and-control structures meanwhile would remain in the NATO framework and ultimate national sovereignty would be preserved.

After a short discussion about how sovereignty concerns have so far impeded EU defense integration, we argue that air defense is a European public good. Because of the substantial costs and economies of scale, provisioning by any country would be insufficient – air defense would benefit from European funding.

Adequate funding governance for air defense can be put in place to account for continuing differences between countries in preferences and for distributional effects. Moreover, since air defense is a major investment, there is a case to fund it via deficits. We provide detailed arguments for that. We then discuss the legal base for a European debt instrument that permits debt funding while respecting limitations in scope, quantity and time.

Sovereignty concerns

Defense and military capabilities are considered core sovereignty issues and reflect the ability of countries to effectively exercise state power (Dobbs, 2014). Some national constitutional courts have identified defense as a core function for the sovereignty of the nation state, and core defense capabilities would therefore have to remain under national control, making any significant transfer of competence possibly unconstitutional (GFCC, 2009).

The sensitivity of defense as issue of national concern is further reflected in the very limited integration in the area of defense throughout the EU integration process after the French rejection in 1954 of the formation of a European Defense Community. Accordingly, the EU Treaties flag defense and military issues as areas of national competence, with EU-based defense activities limited in scope and constrained by unanimity voting.

European defense integration does however enjoy consistently high levels of public support (Mérand and Angers, 2014). Genschel and Jachtenfuchs (2015) identified the increasing integration – without federalisation – of core state powers, including defense, in the EU. Strategic threat perceptions can influence public opinion on European defense cooperation and integration – in particular the perception that Russia’s military activities in Ukraine threaten security – and increase support for the creation of a common European army (Graf, 2020).

Crises can counter the “constraining dissensus” in relation to defense integration (Burgoon et al, 2023), and there is both cross-border support for European defense and converging preferences on the actual design of such a policy. Unsurprisingly perhaps, a somewhat ad-hoc German proposal on air defense, the European Sky Shield Initiative (ESSI) , proposed in August 2022 by Chancellor Scholz as an initiative to strengthen the European pillar of NATO and build up capabilities in air defense, has attracted the participation and interest of more than 20 states. ESSI involves procurement, maintenance and use under NATO command of air-defense capabilities.

However, France is not part of ESSI and has criticized the initiative, in part because of its focus on US and Israeli defense companies. France’s criticisms also relate to differences in deterrence doctrines, and political, economic and industrial policy questions (Arnold and Arnold, 2023). Since the establishment of ESSI, some convergence has been achieved on these issues and French president Emmanuel Macron has recognized explicitly the importance of ESSI for countries without nuclear deterrence.

To make EU-level debt funding for air defense acceptable, it will be important to strengthen interoperability of systems and include at least to some degree the French-Italian SAMP-T system alongside IRIS-T and other European systems.

In this context, EU funding for air defense could initially focus on R&D to advance interoperability. R&D funding could even focus on developing new EU systems able to intercept ballistic missiles. In a second step, EU funding would be used for the roll-out of such systems. While this approach may be politically more acceptable, such a staggered process risks taking too long.

As Europe is currently vulnerable to air attacks, it is important to increase air-defense capabilities rapidly. In practice, it may therefore be necessary to advance along parallel R&D and procurement tracks. Purchases of the equipment necessary to protect critical infrastructure could start immediately, even if from foreign producers, while additional EU funding could be used to advance the development of EU systems.

If new EU debt were created to pay for air defense, purchases from US companies, as being done under ESSI, would not crowd out European industrial development. Moreover, while EU debt financing would be strictly limited in volume and scope to European air defense (mainly for legal reasons; see section 4.2), the financial investments would also provide long-term funding that would give the necessary stability to industrial policy and fiscal forward guidance for the industry to enhance production capacities.

Building-up the air-defense capacities of domestic defense companies will provide a diversity of systems, making European air defense more resilient to possible disruptions related to foreign suppliers. In short, EU debt would allow short-term needs to be met through procurement from abroad while also nurturing the build-up of an EU defense industry.

Since air defense is an issue for Europe as a whole, any EU funding initiative should be open to European allies, including the United Kingdom and Norway, which are part of the same airspace that needs to be defended (and which are already part of ESSI). While our proposed EU borrowing mechanism would focus on EU procurement, non-EU allies could participate in some form.

A European public good (EPG) can be defined as a good not supplied at an adequate level without public intervention (Fuest and Pisani-Ferry, 2020), and which should be provided, at least partially, at EU level to internalize externalities and reap benefits of scale, notwithstanding potential differences in national or local preferences (Claeys and Steinbach, 2024).

State-level defense has long been considered a public good but to what extent is defense a European public good? The EPG definition comes from the fiscal federalism literature (Tiebout, 1956; Oates, 1972; Alesina et al, 2005) and does not necessarily apply to the same extent to all aspects of defense.

In the EU and NATO, any national army provides to some extent a public good beyond its own security because it can be called up and contribute to collective defense via Article 5 of the NATO Treaty and Article 42(7) of the Treaty on the Functioning of European Union. This is a direct way of contributing to collective deterrence and thereby shows that national defense capacities are, at least to some extent, a European public good.

Also, in case of threats from state and non-state actors that may use cheap drones and missiles to attack EU territory, border states play an important role in intercepting incoming threats to the benefit of the EU as a whole. As countries can, at least to some extent, count on assistance by others, there is an incentive to free ride on others’ provisioning of military services.

Air defense is particularly subject to strong scale effects and externalities (Beetsma et al, 2024): When it comes to threat detection, the more that radar and other detection systems are interconnected and the more data is shared, the easier it is to detect threats early on, reducing investment needs for each country. For aircraft, cruise missiles and drones flying at low to medium altitude, countries of first entry should typically act to neutralise the threat, thereby providing a public good to more distant countries that might have been targeted. Even for high-altitude ballistic missiles, detection and neutralisation can be done from countries other than those being targeted.

For example, a ballistic missile fired at the Netherlands will unlikely be intercepted only over the Netherlands. European air defense is therefore a particularly robust public good that few European countries could provide alone. Scale economies and shared benefits thus offer a strong rationale for providing the public good at European rather than national level. With the significant fixed costs for building up air defense, unifying national efforts can untap substantial savings.

The counterargument against air defense as an EPG is that the current threat is primarily Russia and therefore countries in Europe’s South and West may be less affected. It is perhaps no surprise that Spain and Italy have not reached the 2 percent of GDP NATO target for defense spending. However, Western Europe is not necessarily immune from the Russian threat. Moreover, threats are evolving. Future threats could come from other EU neighbors. For example, should North Africa succumb to Islamic State-style Islamists, drones could become a direct threat to Mediterranean countries.

Nevertheless, concerns about European defense integration persist. At the strategic level, there is a worry that an air-defense build-up would upset the balance of power and deterrence between Russia and Europe. This concern relates in particular to high-altitude deterrence, as provided through the Israel/US Arrow 3 system. It is also feared that air defense could attract investment at the expense of deep-strike capacity.

In terms of scale and availability, ESSI has been criticized as relying too strongly on US-based systems, in particular the Patriot system, creating a strategic dependency on the US and limiting availability to the production capacities of the US company Raytheon (which produces the Patriot system). Finally, there is an industrial policy worry that European taxpayer money would boost US defense companies instead of advancing European systems from France and Italy, in particular SAMP-T.

EU countries are gradually converging on these issues. French president Emmanuel Macron has explicitly recognized the importance of ESSI for countries without nuclear deterrence. When it comes to the balance between deterrence and strike capabilities, there is a growing recognition that air defense cannot come at the expense of strike capabilities.

When it comes to strategic dependence, missile manufacturer MDBA Germany is building a factory to produce Patriot missiles, though capacities might still be insufficient and dependencies could persist. And importantly, ESSI includes German systems such as IRIS-T.

Furthermore, drawbacks must be balanced against the advantages of the availability of US systems and their high performance. Moreover, increasing investment in domestic production combined with investments in interoperability should increase the resilience of European air defense against geopolitical risks.

To make debt funding acceptable and to ensure Europe’s air defense industry thrives and that a diversity of systems is available, reducing strategic dependence on any individual supplier, it will be important to strengthen interoperability of systems and include SAMP-T systems, IRIS-T and other European systems in the European funding efforts. It would also be worth allocating a part of the EU funding to developing a European system that can rival current systems from abroad.

Characterizing air defense as an EPG does not necessarily imply that all its elements should be centralized at EU level (Claeys and Steinbach, 2024). Rather, the EU legal and institutional framework offers a menu of design options that allow the governance of the public good to be customized, guided by efficiency and the trade-offs described above.

One design option that would account for highly diverse policy preferences is ‘club good provision’, through which deeper defense cooperation would be pursued by some rather than all EU members contributing to defense as an EPG. The EU Treaties generally allow for club good provision through ‘enhanced cooperation’ (Demertzis et al, 2018; Fuest and Pisani-Ferry, 2019).

One design option offering flexibility in governance would be the existing Permanent Structured Cooperation (PESCO) in defense cooperation in relation to research, procurement and armaments cooperation. Projects involving non-EU countries have also been pursued under the PESCO umbrella. PESCO could thus become the framework for some air defense equipment purchases and for enhancing R&D in air defense in collaboration, where applicable, with the European Defense Agency and the European Defense Fund.

Current frameworks overlap and do not intersect exactly. ESSI includes mainly EU members but also other allies Norway, the UK, Switzerland and Turkey. The PESCO cooperation framework covers 26 EU countries (Malta being the exception). The PESCO framework provides sufficient flexibility for at least the EU ESSI members to cooperate in PESCO projects. ESSI could become a new PESCO project, and its EU country members (out of the 26 PESCO members) could agree on a ‘club good’ based ESSI initiative.

The participating member states would agree among themselves on the arrangements for, and the scope of, their cooperation, and the management of that project. Integrating non-European countries into ESSI is possible under the PESCO architecture, having already been done previously with the integration of the US and Canada into PESCO Military Mobility projects.

The advantage of pursuing ESSI within PESCO is that suitable institutional governance exists that could provide the basis for joint debt financing and could also be used for greater cooperation in procurement and R&D. In particular, integrating ESSI into PESCO would allow resources from the European Defense Agency to be used, for example to enhance the interoperability of different systems and to invest in R&D, including for the French/Italian air defense system.

Providing air defense as public good can be customized depending on whether it is supplied in centralized or decentralized fashion. Our understanding is that, in the outline plan advanced by Commission President von der Leyen, the EU would play no operational role in air defense, which would remain solely the competence of member states within the NATO framework.

Clearly, in a true ‘federal’ EU vision, military decision making, among other things, would one day be centralized, but that vision is not the framework of thinking in this Policy Brief, in which we consider concrete options for decision makers. Some elements of air defense however could be delivered at EU level, including procurement of air-defense systems (eg joint large-scale purchases of military equipment).

For that option to advance, member states would have to agree on what systems are particularly suited for joint purchases and which are better procured with existing, though often slow, domestic procurement approaches. In case of a less-ambitious approach, procurement could remain national but under a joint framework contract. Joint debt issuance would not require the European Commission to decide on spending, as this would remain the responsibility of member states, or if centrally decided, subject to unanimity in the Council of the EU.

Finally, even if there is a strong efficiency case to supply air defense as an EPG, centralization may have distributional effects. Joint procurement may create losers as well as winners and incumbent industrial players might seek compensation as they lose their (national) market shares. The political implications of this must be taken into account, while understanding that additional EU debt would grow the market for defense products substantially.

In a growing market, it would be a mistake for incumbent industrial players and governments to merely seek to retain national market shares. Rather, they should accept the importance of cost effectiveness and competition in overall conditions conducive to more revenues.

It is thus true both that joint, as opposed to national, procurement of air defense systems can revitalize competition, break up national markets and threaten national ‘champions’ (Burgoon et al, 2023), while simultaneously these national companies could grow substantially, as shown by the extraordinarily positive stock market performance of European defense companies since 2022.

Nevertheless, some compensation mechanisms may still be politically advisable to strengthen domestic defense industrial bases that would not benefit directly from EU-funded ESSI procurement. We thus recommend including TWISTER (the Timely Warning and Interception with Space-based Theatre surveillance project, led by MDBA) and the Franco-Italian SAMP/T in the purchases and the R&D phase.

Joint debt issuance and joint procurement would thus also increase budgetary resources for such domestic defense systems. Another mechanism would be to adapt, where necessary, existing EU funds to cushion adverse effects felt by regions (eg Structural Funds or the Just Transition Fund).

Debt-financing ESSI

PESCO projects are generally financed by the participating countries. In terms of air defense, joint debt issuance could increase the resources to fund procurement. While procurement and funding would ideally be centralized to achieve efficiency gains, it is likely and possible that funds raised from issuance of EU debt would be first disbursed to EU countries, which would then spend them on ESSI projects in the context of PESCO.

The economic rationale for debt funding air defense is straightforward: building air-defense systems represents a huge upfront investment. Once the system is in place, operational costs are relatively small. Large upfront investments should be funded by deficits for tax-smoothing reasons, and to spread costs over the periods during which systems will be operational.

The legal implementation of exceptional debt financing for ESSI is challenging but feasible. There are two major legal issues, the first related to the financing of defense from the EU budget, and the second related to debt-financing for EU defense expenditure. For both issues, the mechanism must evidently comply with EU law, but national constitutional law also poses constraints. In particular the German Constitutional Court’s concerns about EU debt should not be ignored in order to minimize legal challenges that could arise if decisions are brought before the German Constitutional Court.

There is a general restriction, stipulated in Article 41(2) of the Treaty on European Union, that prevents the EU budget from funding expenditure related to operations with military or defense implications. However, this provision has not stood in the way of the recent evolution towards an EU defense union.

Despite its limited competence in defense, the EU has advanced joint procurement of defense equipment through the European defense industry reinforcement through common procurement act (EDIRPA, Regulation (EU) 2023/2418) and has stepped up production to sustain ammunition and missile deliveries from Europe to Ukraine through the Act in Support of Ammunition Production (ASAP, Regulation (EU) 2023/1525).

These initiatives, built on the EU’s internal market and industrial policy competence (Articles 113 TFEU and 173(3) TFEU), are a combination of building up EU military capability and industrial capacity. These initiatives do not conflict with Article 41(2) TEU because they entail development of military capabilities, not defense operations (Fabbrini, 2024).

Unlike these initiatives, ESSI would go beyond propping up capabilities through joint development by purchasing military equipment, though not operational deployment of ESSI capabilities. Article 41(2) TEU thus requires such purchases to be made outside the regular budget. The EU has been dealing with this restriction through the framework of the European Peace Facility, an off-budget fund that allows EU countries to purchase lethal and non-lethal military support.

In addition to basing ESSI on internal market and industrial policy competences, a proper legal basis to permit debt-based funding can be found in Article 311 TFEU (for borrowing) and in Title V of the TEU on Common Foreign and Security Policy, in combination with Article 122 TFEU (for spending). Our solution would introduce EU borrowing ‘off-budget’ and outside the regular EU budget (similar to the EU post-pandemic economic recovery initiative, NextGenerationEU, NGEU).

Proceeds from credits that are bound to go into grants to finance ESSI would be so-called “externally assigned revenues”, as they were treated under NGEU. These revenues are not part of the annual EU budget, nor of the EU’s seven-year multiannual financial framework, because assigned revenues are not decided on under the annual budget procedure (CLS, 2020, para. 34).

Through such an ‘off-budget’ design, debt-financing of ESSI as defense expenditure would not violate the general ban on financing of defense from the EU budget. In any case, one must consider that the ban on using the EU budget for defense has two objectives. First, it seeks to protect neutral EU members from having to pay for military expenses. In our proposal, this protection is respected in any case through the Own Resources Decision (ORD, the decision of EU countries on resources for the EU budget), which would be the legal basis for debt funding. This decision requires unanimity, meaning approval by all EU members including neutral states.

Second, the intention of keeping military expenses out of the EU budget is to preclude the European Parliament having co-decision rights (Achenbach, 2022). By keeping the parliament out of decision-making over defense and military issues, EU countries wanted to protect their prerogatives on these sensitive affairs. Again, our proposal foresees – just like under NGEU – no co-decision rights for the European Parliament, which is not able to vote on NGEU revenues and expenditure. In sum, the EU Treaties do not categorically preclude members from jointly debt-financing defense and military projects.

Since our proposal means designing EU debt financing similarly to how it was set up under NGEU, a distinction must be made between borrowing for ESSI purposes and spending on ESSI activities. The European Commission is enabled to borrow on the EU’s behalf by the ORD (Grund and Steinbach, 2023). The ORD requires a unanimous Council decision that designates the main sources of EU financing and requires ratification by each member state.

The ORD authorizes borrowing and specifies how the borrowing proceeds are to be used. This implies that borrowing for air defense requires a new ORD and hence requires ratification by EU countries in line with domestic constitutions (Article 311 TFEU). The German Constitutional Court has stipulated a number of limitations on EU debt financing that the overall borrowed funds may not exceed significantly the amount of own resources (GFCC, 2022; see footnote 18). Taking into account the existing stock of NGEU debt, there is thus a ceiling on permissible debt.

Spending of the funds raised needs to have a distinct legal anchor. For NGEU, this was the emergency clause in the EU Treaties (Article 122 TFEU), which permits the financing of targeted and temporary economic measures in exceptional situations. The emergency clause requires linking the use of borrowed funds to the addressing of the “exceptional occurrence” within the meaning of Article 122 TFEU. Despite obvious differences with NGEU, the creation of an ESSI-based air defense system can be likened to an emergency under Article 122 TFEU, in which EU countries permit mutual assistance to tackle an immediate security threat.

Since individual EU countries are economically unable to finance ESSI, joint spending responds to the emergency situation. In conjunction with Article 122 TFEU, the EU can base ESSI expenditure on its CFSP competences under Title V of TEU (and the PESCO framework, in particular), which gives member states sufficient leeway to adopt an instrument like ESSI that aims at promoting defense and security.

Russia’s full-scale attack on Ukraine was a shock that has put at risk the security of the EU and its members. There is broad consensus that Russian territorial imperialism is a direct threat to EU security, which over time has intensified and increasingly threatens individual EU countries (see, for example, Cavoli, 2024).

The German Constitutional Court further ruled that debt financing must be limited in duration and substance (GFCC, 2022). A military assault on an EU immediate neighborhood country can be considered an “historically exceptional case” in line with the court’s findings (GFCC, 2022). Even today, the direct threat of a Russian attack on EU territory is visible. Increased hybrid attacks and stray missiles reportedly reaching EU territory are among the indicators of the immediacy of the threat, as is the strong build-up of Russian military production capacities (Wolff et al, 2024).

Each EU countries individually would not be able to protect its skies sufficiently. To account for the balanced-budget principle, the ORD must provide for sufficient future genuine own resources to ensure repayment of the debt. This is necessary to counterbalance the debt resulting from the borrowing by an asset, which justifies its off-budget treatment (CLS, 2020).

NGEU has been implemented through national Recovery and Resilience Plans, based on Article 175 TFEU, which follow a certain bottom-up logic with EU countries proposing projects which are then approved by Commission and Council. This approach ensured member-state ownership and a fair distribution of means. For air defense, there is no need to rely on Article 175 TFEU as a distributional device. Rather, the PESCO framework under Article 46 TEU offers the appropriate framework for the Commission and EU countries to decide which systems should be procured through joint purchases, or which should continue to be procured by member states – a decision that should be guided by cost-efficiency considerations.

Conclusions

The increased threat perception has shifted sentiment in Europe and the building up of defense capabilities has increased in importance in many countries. Surveys also indicate that citizens want the EU to play a greater role in defense. It is therefore no surprise that the German initiative to build up a European air defense system – ESSI – has been welcomed and endorsed by more than 20 European countries. Yet, France and Italy in particular have expressed some reservations about the initiative, even though some strategic convergence became visible during 2023.

Joint EU debt funding would be appropriate to boost European air defense. Joint funding can be justified by the fact that air defense is an EPG with significant externalities and spillovers. Debt funding is appropriate since air defense system build-up requires high upfront costs. Such debt funding could follow a model close to NGEU. Such a legal construction would be tenable.

Policymakers should act rapidly to set up such a major EU debt programmed to boost European security in a spirit of solidarity between European countries. This would free-up national fiscal resources for other urgently needed defense systems. ESSI should be adjusted to take into account justified industrial policy concerns and to support R&D into the interoperability of systems and the enhancement of European technology in air defense.

Finally, policymakers must find ways to include non-EU ESSI members in the effort. On the whole, EU debt would allow European defense efforts to be advanced greatly in a highly threatening security environment. Joint EU debt funding would internalize the major security externalities of air defense, be treaty compatible and politically highly welcome, all without detracting from EU industrial policy objectives.