Europe: Adjusting fiscal policies to bolster defense

■ The focus of the 2025 "European Semester" policy will shift from returning to the Stability and Growth Pact to strengthening defense.  
■ The yield gap between the 10-year U.S. and German government bonds continues to narrow, which may indicate the expansion of Europe's structural fiscal deficit. 
 
   On June 4, the European Commission announced the spring policy package for the 2025 budget approval process of EU member states, known as the "European Semester." This policy package is based on guidelines proposed by the European Commission last autumn. After each member state develops its medium-term fiscal plan, the European Commission will evaluate, report, and make recommendations on it individually.  
 
   Taking into account increasing threats to trade and security, this spring's policy package agreed to the "National Escape Clause" (NEC) in the Stability and Growth Pact (SGP), proposed by 12 countries, including Germany. Last autumn, the European Commission prioritized restoring government spending after the pandemic and returning to the SGP framework. However, as the U.S. demonstrated a clear stance of reducing its participation in European security, the European Commission shifted its policy focus toward ensuring fiscal flexibility and promoting increased defense spending. This change aligns with the proposed 800-billion-euro defense spending and related investment fund in the "ReArm Europe Plan/Readiness 2030" strategy, as well as the fiscal flexibility enabled by the NEC. It is anticipated that this one-time increase in expenditure will also be permitted in the budgets of member states in 2026, marking an official future move. As a result, the restraining effect of the SGP on defense spending is weakening.  
 
   The rise in defense spending is gradually becoming a reality. On June 25, NATO members agreed to increase defense-related spending to 5% of nominal GDP by 2035. On June 24, Germany approved its 2025 and 2026 budget frameworks, incorporating the increases in public investment and defense spending promised by the ruling coalition. Some funds will be raised through borrowing from the newly established infrastructure fund, and the constitutional "debt brake" (fiscal deficit limit) will be temporarily waived. The plan, expected to last until 2029, includes large-scale infrastructure investments and defense expenditures, leading to an inevitable rise in the fiscal deficit.  
 
   Across Europe, fiscal deficits and government bond issuance are expected to rise accordingly. While the EU has traditionally emphasized fiscal discipline to curb member states' fiscal expansion, the importance of the bond market in maintaining this discipline will grow. Despite continued interest rate cuts by the European Central Bank (ECB) and doubts about the sustainability of U.S. debt, the yield spread between U.S. and German 10-year government bonds has been narrowing since the new U.S. administration took office in January. This indicates that German 10-year bond yields are likely to stop falling relative to U.S. bonds, reflecting market concern about Europe's expanding structural fiscal deficits.