The EU should issue common European defense bonds for Ukraine now

Wars and the need to finance them have historically driven national identities and formed the modern states of Europe.¹ Russia's war in Ukraine poses a crisis that could now push Europe to rapidly integrate its finances and institutions to help secure a Ukrainian victory by issuing an initial €100 billion in common European defense bonds, as proposed by Prime Minister Kaja Kallas of Estonia and President Emmanuel Macron of France.

The disbursed and committed financial support from EU institutions and member states for Ukraine totals about €180 billion, with institutions accounting for €77 billion. European defense bonds, which will not count towards EU member debt limits, can complement that assistance and be approved by the member states' leaders in the European Council on June 28–29.

The need for additional aid is urgent. The United States approved $61 billion for its most recent aid package earlier this year, bringing its total pledged aid to well over $100 billion. But it is unclear if additional future funding can pass Congress no matter who wins the presidential election in November.

The United States has also enacted the REPO Act, authorizing the seizure of $5 billion to $8 billion in Russian state assets in the United States to be handed over to Ukraine. The Biden administration has called for accessing $250 billion of Russian state assets frozen in Europe. The French and German governments have rejected outright confiscation of Russian assets in the European Union, but countries at the G7 Summit in mid-June may agree to using these assets to generate a securitized stream of future income to underwrite a possible $50 billion upfront loan to Ukraine. Currently, agreement on the issue hinges on the unanimous consent of all EU members (including of Hungary's pro-Russian prime minister Viktor Orban) to renew sanctions on Russia, which expire every six months, as Russian assets will need to remain frozen to yield income for many years. If agreement can be reached, this revenue source would amount to a big cash infusion for Ukraine earlier than the recent EU agreement to confiscate the approximate $3 billion to $4 billion in annual profits from Russian assets in the European Union.

A broader post-war peace settlement could turn Russia's frozen assets over to a theoretically victorious Ukraine. But accessing these assets now to sustain Ukraine's war effort could jeopardize using such funds for Ukrainian reconstruction. The United States may not be in a position to pay for Ukraine's reconstruction, a job more likely to fall on European shoulders, so seizing or securitizing assets for the war effort would seem to be more attractive to Washington.

No matter what happens to Russia's frozen assets, the European Union will have to find more money for Ukraine. Seizing or securitizing Russian assets could strengthen the reluctance of some in Europe to provide more direct aid. The time for European defense bonds is therefore now.

The EU cannot rely on the US for military aid to Ukraine, which is vital for its own security against Russia

The European Union's need to secure a militarily victorious Ukraine is self-evident given the uncertainty of sustaining aid in Washington, where the main security concern is focused on China. Accordingly, the European Union has no choice other than to become far more militarily self-sufficient in order to ensure a victorious, rebuilt, democratic, market economy–based Ukraine that, with EU membership, will be one cornerstone of Europe's long-term security and deterrence against an expansionist despotic Russia. A Russian victory will be far more costly than any aid provided to prevent such a thing from happening.

Up to €100 billion of the bilateral aid from EU members has been granted disproportionately by countries closer to the Russian border. Estonia provides the most as a share of GDP, Portugal not so much. This is illustrated in the map below based on the Ukraine aid data from the Kiel Institute for the World Economy.

The geographic breakdown indicates that many of the traditionally frugal EU members, generally opposed to common EU funding for any issue, are "all in" for Ukraine. For this group of countries, agreeing to such funding for Ukraine through European defense bonds makes national economic sense, as it spreads the cost of providing necessary European assistance to all EU members evenly. (Eurobonds are underwritten by the European Union's collective budget, whose distribution reflects member GDP and national income levels. They were last issued during the pandemic.)

EU members will benefit from common defense spending, as they did during the pandemic

The most indebted EU countries, such as Italy and Greece, have an additional self-interest in agreeing to European defense bonds. In 2020, the creation of the NextGenerationEU (NGEU) pandemic recovery fund represented a breakthrough in EU fiscal integration, showing the European Union capable of agreeing on large-scale common funding to address unforeseen external threats affecting all member states to roughly the same degree. Not all crises will fit these criteria, and NGEU is far from a permanent central EU fiscal capacity comparable to traditional government countercyclical policy.

At the same time, the NGEU fund has been a testament to the European Union's ability to come together under certain conditions, a development that benefits the most indebted EU members, especially Italy, with less latent fiscal space to deploy in a future unforeseen crisis. In cases of centralized EU debt and expenditures, the most indebted EU member states will receive a relatively higher national benefit than less indebted members. The centralized nature of NGEU expenditures has hence had a stabilizing impact on finances, in turn likely responsible in part for the relatively low interest rate spreads between national Italian and German bonds since the pandemic.

If, however, in the face of a similar external threat to the entire continent, the European Union were to fail to replicate the common action taken with the NGEU, it would represent a step backwards for EU integration. Any longer-run stabilization effect on financial markets that was achieved through the pandemic response during the summer of 2020 would be forfeited. The military threat Russia's invasion of Ukraine represents to all of Europe mirrors the shared threat of the pandemic that yielded the political space to create the NGEU. It is a cliché to say that a crisis should not go to waste, but failure to provide adequate common funding for Ukraine risks increasing financial instability in the European Union. Supporting Ukraine is consequently in the European Union's own interest.

Ideally, European defense bonds would be approved by all 27 member states at the upcoming European Council meeting on June 28–29 and issued by the European Commission as part of the regular EU bond issuances. This would maximize liquidity for these bonds among international investors. If, however, Viktor Orban vetoes such bonds backed by all member states via the EU budget, the European Stability Mechanism (ESM) should be mobilized.

Like the European Union itself, the ESM has an AAA rating and no longer faces obvious tasks on which to spend its available capital.² The ESM, complemented by the proportional voluntary bilateral contributions from willing non-eurozone members, excluding Hungary, could then proceed to issue or guarantee the agreed level of European defense bonds.

What should European defense bonds fund?

Important questions relate to precisely what European defense bonds should be used for. Most obviously, the bonds would fund military assistance to Ukraine, but one might also argue that they could fund a common EU air defense system to protect against future Russian missile and air threats or to directly build up the revamped EU military industrial sector by funding parts of its own defense expenditures.

At the same time, individual member states bear the sole responsibility of defending EU territory, and it is not clear that members that have historically failed to invest adequately in defense should be relieved of such spending through commonly funded defense investments. In other words, common defense funding is subject to a mild version of the type of moral hazard concerns that have traditionally made common EU funding politically unacceptable. Member states without an underfunded national defense budget are not going to want to use common funds to make up for years of neglected defense spending in many of the richer EU members, such as Denmark and Germany.

It would be best to limit European defense bonds to the direct military support for Ukraine, at least initially. This will make them politically feasible now.

Notes

1. See for instance Charles Tilly's Coercion, Capital and European States (1992) for one among many studies of the link between wars, taxation, and state formation.

2. While it is legally plausible that the ESM Treaty might have to be amended for the ESM to anchor the issuance of European defense bonds, this seems a manageable political task.