The US wants out of Europe. This leaves the continent vulnerable to a large neighbor that is projected to outspend all European countries combined next year, when it comes to effective defense spending. So, now, in Europe the debate has begun, what parts of the welfare state should they cut so that Europeans can afford to defend themselves? Should they reduce healthcare spending? Education spending? Or social protection?
This entire debate is nonsense.
That’s right, in this video, I’m going to make the case that the US leaving Europe to defend itself will make Europe’s economy stronger, not weaker. Therefore, increased defense will NOT require cutting Europe’s welfare state.
Now, look, I realize that is a bold claim. In fact, if we think about Europe as a person, like you and me, who needs to spend less on something to be able to spend more on something else, my claim makes no sense at all.
But, entire economic systems work in very different ways than our personal finances. So, to find out how increased defense spending will make Europe’s economy great again, let’s do a quick refresher on our
Macroeconomics 101
If we look at macroeconomics in its simplest form, the economy is a system of people and machines, also known as labor and capital. People work some hours and using machines they produce goods and services. The value of these goods and services is the what we call total output, or GDP.
If an economy is operating at its full capacity, then there is very low unemployment and there are hardly any idle factories.
If such a society wants to get more people into the army, it means that companies can make fewer consumer goods. But, because soldiers still provide a service —defense— GDP may remain the same. However, given that soldiers still earn money, and therefore want to keep buying consumer goods, of which less is now produced, this may cause their price to rise.
Consumer prices going up. That is inflation.
So, in this case, thanks to the extra defense spending, the economy has reached the limits of its capacity to meet all of the demand, which causes inflation. Economists call this overheating.
A well-run economy should have low unemployment and high capacity utilization. It employs all the resources that it has available and therefore grows slowly as technology progresses. As we’ve seen, if a war comes along, such an economy will be pushed above its sustainable potential, causing inflation.
This framework can explain what happened to Israel after October 2023, or to Russia today. Before their wars, these economies were roughly at full potential, with really low unemployment. Then, when their respective wars started, it pushed these economy temporarily above potential, producing inflation.
Therefore, these countries are facing a trade-off between three desirable things: high defense spending, high civilian spending, and low inflation. An economy that is at full capacity cannot have all three of these desirable things. Therefore, we could call this the war economy trilemma.
After October 2023, Israel was facing this trilemma. Initially, it spent more on defense, and saw inflation go up. Therefore, it initially raised interest rates to reduce civilian spending. But then, in 2024, it ultimately called off a full-scale invasion of Lebanon, likely partially due to economic concerns.
On the other hand, Russia has chosen to both raise interest rates and accept higher inflation for now to be able to continues it massive war spending efforts to subdue Ukraine.
Now, using this framework, we already have learned something interesting about Europeans. High inflation is not an option! Europeans don’t control their central bank. So, obviously, the only option is to cut government spending on welfare. In this context, the current debate makes total sense.
If the European economy was at or near its full capacity. I would be on board with this debate. I’m not a fan of inflation. I’m not advocating for ever increasing government debt.
But, in this video, I’m going to make main 2 claims. The first is that Europe’s economy is operating well below it’s potential. And, the second is that the proposed increase in defense spending is small enough to get its economy closer to potential, without pushing it above its potential.
Therefore, the war economy trilemma framework is NOT YET the right framework to talk about Europe, BECAUSE America leaving, will make Europe’s economy stronger by bringing its economy closer to its potential.
But, okay, this channel is an analysis channel. The goal is to understand our economies based on evidence. So, what is my evidence to back up these claims?
For claim number 1, Europe is operating well below it’s potential, I have 3 pieces of evidence. First, Europe’s unemployment rate is well above that of the United States, and has been for a very long time.
Second, Europe’s capacity utilization, how much it uses its factories, has kept dropping after Covid, meaning that there are plenty of spare factories, especially in Germany.
Finally, while Europe did see quite a bit of inflation, most research indicates that this was primarily caused by Covid supply disruptions and then by skyrocketing energy prices.
However, crucially, if Europe needs to spend too much on increasing its defense, then of course, we’ll still get to the war economy trilemma trade-off. But, that is currently not the case for four reasons.
First, when it comes to manpower, European think tank Bruegel has estimated that Europe will need about 300 000 new soldiers if American troops were to leave. At the same time, there are almost 13 million unemployed people in the EU. So, while, of course, not all unemployed people are fit to serve in the army, there’s a really wide margin of error here.
Second, when it comes to utilizing Europe’s factories, there are some really hopeful signs that Europe CAN produce enough military material. First of all, while Europe does rely on the US quite a bit, especially for air defense, Europe’s military industrial complex is still well diversified enough overall, especially in France, which never fully trusted the US and therefore, maintained military capabilities across all domains.
Third, Europe still has a good industrial base when it comes to industries that can be transformed relatively easily to make war materials For example, Europe produces input materials like chemicals and steel on a much greater level than the United States AND it increasingly now has empty car factories that can be repurposed. In fact, this is already in happening in Germany, where German defense company Rheinmetal recently announced it may repurpose several Volkswagen factories to make armored vehicles.
Finally, when it comes to spending in general, Bruegel and NATO have estimated that Europe needs to raise spending from 1.87% of GDP to 3 or 3.5% respectively. That is still only half of what economies like Russia and Israel are spending on defense today.
Therefore, I think it is likely the current defense spending increase WILL push Europe’s economy CLOSER to its potential, rather than over it, making the continent’s economy stronger, and thereby keeping government debt loads manageable and avoiding inflation.
However, at this point you may ask. But, hold on a second, if Europe’s economy is operating BELOW its potential, do we really need DEFENSE spending to get it back to potential? Can’t we instead spend on NICER things like education or healthcare?
NO. After all, Europe HAS BEEN operating FAR MORE below its potential than the US FOR A LONG TIME ALREADY. So, on its own Europe has not been able to bring its economy to potential. But, why? In other words,
Why does Europe need a military threat to activate its entire economy?
To answer that question, I think it is important to emphasize that there IS essentially no European economy. That is, there is NO European GOVERNMENT that can decide to increase spending to lift Europe’s economy TOWARDS its potential.
Instead, there are countries with exceptionally LOW government debt in the NORTH and countries with exceptionally high government debt in the South. The Northern economies are considered to be VERY competitive and have very low unemployment, while those in the South have very high unemployment and are considered UNCOMPETITIVE.
If we follow standard economic theory, wages in the North should rise, as workers are in short supply there. This would then make these countries LESS competitive, compelling industry to move to the South. This would make the SOUTH more competitive, lowering unemployment, and lowering the government DEBT burden as these economies grow.
However, in Europe, this balancing mechanism is blocked for two reasons. First, Northern countries have long complained that Southern governments are too eager to regulate and overspend, which kept wages relatively high.
This is why they forced austerity on the South after the Euro crisis. Since then, countries like Spain, HAVE become more competitive. However, despite significant labor market reforms, Southern countries have still struggled to attract sufficient companies.
Many economists have pointed out that this is because the BALANCING mechanism was NOT JUST blocked by the South. But, ALSO by the north, whose governments have artificially suppressed wages through collective bargaining and by keeping government investment spending lower than it should be, especially in Germany.
This dynamic means that Southern countries operate below their potential because they cannot get out of debt. But, even more strikingly, it means North European countries operate BELOW their potential BY CHOICE. North European workers have CHOSEN to accept lower wages voluntarily and North European voters kept voting in parties that UNDERINVESTED in infrastructure and education.
Why would they do that?
Well, according to economists like Berkely professor Barry Eichengreen, this can for a large part be explained by the fact that European economies have fixed exchange rates, or something similar in the form of the Euro.
You see, if exchange rates cannot be adjusted, a country that is too competitive will accumulate Euros. But, if a country is not competitive enough, it will run out of Euro’s completely, causing a massive crisis such as the one the South experienced in 2011.
This theory can explain why, WITHOUT an external threat, Europe’s economy WILL BE run at a level BELOW what it is capable off. Northern countries underinvest and keep wages low, hurting their economies, so that they can stay on top of the economic pecking order. This hurts the Southern Economies which cannot easily become competitive given that the NATURAL balancing mechanism is blocked.
But, now, with a strong external threat, this dynamic is shattered. Poland and, more importantly, Germany are now turning on the spending taps. This may slightly overheat their economies. But, as these economies import more from the South -especially from Italy which is Europe’s 2nd industrial powerhouse after Germany- this will enable indebted Southern governments to spend more as well.
In other words, increased defense spending in the North will unlock a virtuous economic cycle, in which increased spending in the North, unlocks increased spending in the South, which again unlocks more spending in the North, right until Europe’s economy reaches its potential.
This means that we don’t have to talk about cutting the welfare state just yet, as the war economic trilemma is NOT YET applicable to Europe.
At least, that is the case, that I am making in this video. But, could it be that I am wrong? Yes. Of course.
You see, on this channel, I make economic analysis based on data and economic theories. I try to be as transparent as I can about the specific data and theories that I use. However, the world of macroeconomics is highly uncertain. It depends on the actions of unpredictable politicians. On top of that, we don’t have access to all the data.
So, what are the main assumptions that I made, and how could they be wrong?
First, I assumed that the estimates about extra spending and manpower by Bruegel are correct. However, these are estimates are based on the current situation on the battlefield, in which the Ukrainians are just holding out against the Russian. But, what if Ukraine falls, in that case Europe may need to spend A LOT MORE as Russia just got a lot stronger.
My second big assumption was that Europe’s economy is below it’s potential based on current unemployment, industrial capacity, and inflation data. However, thanks to rapid ageing, Europe’s economic potential could rapidly come down.
Actually, I think this is the WEAKEST part of my analysis. In the next 25 years, Europe’s working age population is projected by the UN to decrease by about 50 million. This is far more than the people who are currently unemployed. This could quickly bring the continent to its potential output, and may mean difficult choices need to be made after all.
However, 25 years is a long time. Europe could increase defense spending NOW to bring the economy up to its potential and then REDUCE defense spending as its population ages. After all, Russia’s population is also projected to fall quickly.
On top of that, European defense spending could become a lot CHEAPER if it was centralized rather than done by each country on their own. Finally, population projections are not everything. Migration can change it substantially. For example, Spain’s population was also projected to decline due to low fertility. But, instead it is rapidly rising thanks to migration from Latin America.
Finally, I think it is important to highlight that I assumed that Europe’s divided nature is keeping it back. As we’ve seen, this is a respectable economic theory. But, it is not the only one. Another theory is that excessive regulation is holding it back. But, if that was true, I’d argue that we still don’t need to cut the welfare state now, we should cut regulation instead.
So, whichever road I followed, I came to the same conclusion, America’s defensive retreat, while extremely regrettable, and IMPORTANTLY horrible for the people of Ukraine, does have a silver lining: it will make Europe’s economy stronger.
But, of course, there are many more American allies than just the Europeans that find themselves in the same predicament as Europe. What should they do? You can read all about that in the Sponsor of this video: The Economist, where
I highly recommend you follow up this video by reading their analysis on how these countries should respond. Then, to lift your spirits, read up on their analysis of how Putin aims to trap Donald Trump, and finally I recommend you check out this article about how the war has allowed Ukraine’s powerful drone industry to come to life.
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