Most eurozone states could face extra spending of at least 3% of GDP by 2040

European governments face mounting pressure to fund defence, pensions and healthcare while meeting higher debt-servicing costs, with weak growth limiting their options, according to a Morgan Stanley analysis published on July 20, 2026. Without policy changes, those competing demands could raise public spending by at least three percentage points of gross domestic product (GDP) in most eurozone countries by 2040.

Morgan Stanley expects governments to face difficult budget choices over the coming decade as they try to sustain growth without adding to debt. For decades, falling defence expenditure and debt-servicing costs helped European countries expand welfare programmes. Ageing populations, higher interest costs and geopolitical tensions have reversed that advantage.

“Borrowing cannot be the only answer,” said Jens Eisenschmidt, chief Europe economist at Morgan Stanley Research. “Markets will reward plans that boost growth, not debt.”

Europe’s fiscal pressures have also intensified as the Russia–Ukraine war continues into its fifth year and conflict in the Middle East raises energy costs. Governments already carrying high debt and persistent deficits face demands to accelerate defence spending while financing increasingly expensive public services.

High debt limits Europe’s capacity to absorb rising costs

Morgan Stanley identified France, Italy and Spain as three of the eurozone’s four largest economies with public debt exceeding 100% of GDP, leaving them with limited room to absorb additional spending pressures through borrowing.

Government expenditure already represents almost half of GDP in many European countries, according to Morgan Stanley. Social benefits and transfers, including assistance and subsidies for individuals and families, account for nearly half of total public spending.

Spain and Portugal could face spending increases exceeding five percentage points of GDP by 2040 without policy changes, Morgan Stanley estimated. Austria would experience the smallest increase, at around 1.5 percentage points.

For the United Kingdom, Morgan Stanley projected that pension and defence expenditure would rise by a combined 1.4 percentage points of GDP by 2040. British debt-servicing costs were already above their pre-Covid-19 levels.

Eisenschmidt noted that the sources of pressure differed between countries, but the direction was shared: lower interest bills and declining defence spending were no longer helping governments accommodate other demands.

NATO’s 5% target adds to Europe’s spending pressures

Members of the North Atlantic Treaty Organization (NATO) agreed at their June 2025 summit in The Hague, Netherlands, to raise their defence and security spending commitment to 5% of GDP by 2035, compared with the previous 2% defence benchmark.

NATO’s commitment comprises at least 3.5% of GDP for core defence and up to 1.5% for related security spending, including protection of critical infrastructure, cybersecurity and development of the defence industry.

The NATO agreement followed pressure from US President Donald Trump for European allies to take greater responsibility for their own security, alongside concerns about threats from Russia.

Goldman Sachs Research, in an analysis published before the June 2025 summit, projected that annual European Union (EU) defence spending would be around €80 billion higher by 2027, equivalent to approximately 0.5% of GDP. That earlier scenario put eurozone defence expenditure at 2.4% of GDP in 2027, against 1.8% in 2024.

Goldman Sachs estimated that every additional €100 spent on defence would add about €50 to GDP over two years. The benefit would depend on the type of expenditure and how much military equipment was bought from overseas rather than produced domestically.

Financing the higher defence budgets could involve additional national borrowing, joint EU debt or new lending mechanisms through European financial institutions, Goldman Sachs noted. EU fiscal rules constrained borrowing by individual governments, while joint issuance could provide lower-cost, long-term funding but involved complex approval procedures.

Goldman Sachs argued that Europe could secure greater long-term economic benefits by buying more from regional manufacturers, making military equipment compatible across armed forces and expanding research and development.

IMF and investors warn of Europe’s borrowing constraints

The International Monetary Fund (IMF) has warned that European countries must achieve faster growth or borrow less to keep public debt sustainable. The Fund forecasts eurozone economic growth of 1.1% in 2026 and 1.2% in 2027.

Around three-quarters of European countries need structural reforms to strengthen growth and ease spending pressures, alongside medium-term deficit reductions averaging about 3.5% of GDP, according to the IMF.

Jon Gray, president and chief operating officer of Blackstone, the world’s largest alternative asset manager, has argued that fiscal strains in France, the UK and other European countries present a more urgent risk than those in the United States.

Gray contrasted Europe’s weak growth and large deficits with the US economy’s support from technology investment. Countries carrying debt greater than their annual economic output faced particularly difficult choices, he warned.

High debt burdens aggravated cost-of-living pressures, particularly housing costs, and forced governments to make painful decisions about taxation and welfare, according to Gray.

Fiscal crises were often addressed only when governments were “forced into action by market pressure”, Gray argued, pointing to Greece’s debt restructuring more than a decade ago.

“We are now entering a period where we must face certain realities,” Gray said. He warned that deficits running well above countries’ potential growth rates were fuelling concern because future shocks remained unpredictable.

Morgan Stanley favours budget reallocation over sweeping cuts

Morgan Stanley sees Europe’s central challenge as changing the allocation of existing budgets rather than simply reducing total expenditure. Pensions, healthcare, defence, public safety and debt interest are difficult to cut and, in many cases, are expected to become more expensive.

Eisenschmidt argued that slowing the growth of selected spending categories would be more achievable than imposing broad cuts. If expenditure grew more slowly than the economy, its share of GDP could decline over time.

Morgan Stanley’s proposed approach includes limiting increases in selected expenditure to the rate of inflation while protecting public investment, particularly infrastructure that can improve long-term productivity.

Strengthening Europe’s defence industry through more regional procurement would form another part of the approach. Morgan Stanley also advocated reforms to retirement savings systems to encourage household investment and deepen domestic capital markets, alongside support for private investment in industries with stronger growth potential.

Tax increases could contribute in some countries, but Morgan Stanley does not regard them as a universal solution. Existing tax burdens and political constraints mean governments would need different approaches to raising revenue.

Stronger growth could ease Europe’s budget adjustment

Morgan Stanley’s modelling shows how faster economic growth could create more room in public finances, provided governments also restrain spending. The scenario assumes a pool of expenditure initially worth 25% of GDP is frozen in real terms, meaning its cash value rises only with inflation.

With annual real GDP growth of 1%, Morgan Stanley estimates that this approach could create budgetary room equivalent to around 0.25% of GDP a year. By 2030, the cumulative gain would reach approximately 1.2% of GDP, covering roughly half the required improvement in government balances before interest payments under EU fiscal rules.

With real GDP growth of 2% a year and the same spending restraint, Morgan Stanley projects that the available room could approach 2.3% of GDP by 2030. Under that scenario, governments could potentially meet the required adjustment without additional tax increases or outright spending cuts.

Morgan Stanley’s scenarios are conditional calculations, not growth forecasts. The potential gains depend on both the pace of economic expansion and sustained restraint in the selected spending categories.