Economic incoherence
Paolo Surico is Professor of Economics at the London Business School
Europe’s fiscal framework was designed to discipline public borrowing. Yet shocks from the pandemic and Russia’s invasion of Ukraine have forced governments to stretch the rules. Under the revised Stability and Growth Pact (SGP), member states may exceed deficit limits if the borrowing finances defence.
Politically, the intuition is clear: security cannot wait. Economically, however, the exemption is flawed. Europe is relaxing fiscal rules for the least productive part of defence budgets while constraining the most productive: innovation.
The composition problem
The issue is not how much Europe spends on defence, but what it spends on. Around 40% of EU defence budgets go to personnel, more than one-third to goods and services, and only a small fraction to investment and R&D. Much procurement is imported.
Mejino-López and Wolff (2025) show that Europe’s dependence on the US extends beyond equipment to high-tech systems, software, and associated maintenance. Consequently, a substantial share of borrowing permitted under the defence exemption leaks abroad, supporting US industry more than European technological capability.
By contrast, defence R&D — the component with the highest domestic return — remains chronically small. According to the European Defence Agency (2025), EU defence R&D in 2024 totalled just €13 billion (≈0.07% of EU GDP), compared with $149 billion in the US (≈0.51% of GDP).
Using long historical data for the US, Antolin-Díaz and Surico (2025) find that tilting defence budgets toward R&D generates large and persistent gains in productivity and output, while spending on personnel or equipment delivers far lower long-run returns.
As Aghion and Howitt (1992) emphasise, innovation is inherently disruptive, and technological progress often comes from new entrants. Europe’s concentrated defence-industrial structure, however, gives incumbents weak incentives to adopt technologies that threaten their dominance. A fiscal exemption favouring equipment procurement therefore raises profits for incumbents while discouraging frontier innovation. The exemption thus subsidises the least productive spending while constraining the most productive.
Lessons from the US: from Bush’s endless frontier to a European Office for Scientific Research and Development (OSRD)
Europe’s challenge echoes a pivotal moment in US policy. In 1945, President Roosevelt asked his chief scientific advisor, the MIT-trained engineer Vannevar Bush, to recommend how to convert wartime scientific progress into peacetime prosperity. Bush’s report, Science: The Endless Frontier, outlined a blueprint for what would become the American innovation ecosystem, built on three pillars:
1. Sustained public funding of basic research in areas of broad societal value
2. Strong universities and research institutes pursuing frontier science
3. A private sector capable of commercialising discoveries
This architecture underpinned the National Science Foundation, the tenfold expansion of the National Institutes of Health, and an innovation-driven economy producing breakthroughs from molecular biology to computing. Gazzani et al (2025a, 2025b) report that publicly funded but privately developed innovations have the largest and most persistent effects on productivity and standards of living.
US technological leadership, however, was not built on the Defence Advanced Research Projects Agency (DARPA) alone. DARPA represents just 2–4% of US defence R&D (~$4 billion of $149 billion in 2024). Fieldhouse and Mertens (2025) show that non-defence R&D, particularly in health and education, yields higher social returns than defence R&D.
Gross and Sampat (2025a, 2025b) demonstrate that Bush’s OSRD, coordinating civilian R&D in wartime, was the ultimate engine of peacetime technological progress across electronics, engineering, and biomedical science.
Recent evidence clarifies why. Gazzani et al (2025a, 2025b) show that government-funded innovations have long-term effects not only by advancing the technological frontier but also by crowding in private R&D investment, particularly when funds flow to universities and research institutes. This, in turn, seeds dynamic start-ups and venture capital-backed firms, producing powerful cumulative productivity effects.
Europe can replicate this success by creating a mission-driven, science-centred institution analogous to OSRD, rather than a DARPA clone.
Draghi’s 2024 report offers a blueprint for a mission-oriented, investment-driven research ecosystem. Realising Europe’s “endless frontier moment” depends on translating these recommendations into long-term fiscal and institutional commitments, making innovation central to fiscal strategy rather than discretionary spending.
Improving the EU fiscal framework: exempt innovation, not procurement
Europe’s current fiscal carve-out is economically incoherent. It relaxes deficit rules for spending with limited domestic benefits while constraining investments — especially R&D — that expand long-run productive capacity, reduce dependence on foreign suppliers, and strengthen fiscal sustainability.
A better framework would exempt innovation-related expenditure — particularly public R&D, defence and civilian — while keeping salaries, imported equipment, and routine procurement within deficit limits. Public R&D conducted in Europe, with European firms or joint ventures, would qualify; procurement-heavy spending would not.
Such reform delivers three core benefits:
1. Alignment with growth: borrowing for R&D yields high long-run returns and expands future fiscal capacity (Antolin-Diaz and Surico 2025).
2. Fiscal responsibility: R&D is small relative to total spending and among the most self-financing expenditures.
3. Strategic autonomy: technological leadership — not procurement budgets — defines defence-industrial capability (Mejino-López and Wolff 2025).
Europe’s current fiscal carve-out is economically incoherent. It relaxes deficit rules for spending with limited domestic benefits while constraining investments — especially R&D — that expand long-run productive capacity, reduce dependence on foreign suppliers, and strengthen fiscal sustainability
Operationalising an innovation exemption
Two mechanisms could anchor this shift:
R&D bonds: long-term, earmarked instruments dedicated to exempt R&D spending, allowing investors to link financing directly to productive research.
European Investment Fund (EIF): housed at the European Investment Bank (EIB), pooling and doubling private sector resources in addition to the capital raised from R&D bonds and other channels, significantly expanding existing commitments. Project selection would reflect economic merit and strategic relevance, overseen by a European OSRD-like agency. The fund would support dual-use technologies, strategic digital infrastructure, and the green transition, while multi-sourced procurement would intensify competition among incumbents and start-ups. National equity stakes in the EIF would ensure accountability and visible returns.
Government support to venture capital markets
Policy can also strengthen venture capital markets. Pension reform, tax incentives, and regulatory adjustments can encourage institutional investors — particularly pension funds — to socialise the costs and benefits of a European innovation ecosystem by shifting from low-risk fixed-income assets toward long-term equity. For instance, a more decisive move from defined-benefit to defined-contribution pension schemes would increase funds’ flexibility to invest in higher-risk, higher-return venture capital.
Venture capital funding in Europe remains concentrated in short-horizon sectors, particularly software and services in the UK, where financing risk is lower and exit options are more abundant; by contrast, science-based and long-horizon projects, despite potentially high social returns, are underfunded because they risk failing to secure follow-on financing (Parry 2025).
Policies that incentivise institutional equity investment and targeted support for later-stage start-ups (such as the European Investment Fund equity finance programme) would reduce long-horizon financing risk, improve capital allocation, and counter the migration of European entrepreneurs toward the US ecosystem.
Policy proposals to build a European innovation ecosystem
Innovation thrives on stability. Europe should adopt multi-year public R&D targets, set independently of GDP ratios, to crowd in private investment and ensure continuity across political cycles. Credible, predictable commitments — especially when coupled with guaranteed or lead demand — are powerful incentives for business R&D and venture capital.
Procurement reform is equally urgent. A shift away from sole-source awards to incumbents toward open and competitive calls accessible to both established firms and new entrants is needed. Multi-source procurement, where the same contract or components are awarded to a mix of incumbents and start-ups, would strengthen competition and promote technological integration across the defence industrial base.
Expanding significantly Horizon Europe (budgeted at €7.3 billion in 2024) would reinforce Europe’s innovation backbone: universities, research institutes, and publicly supported laboratories. Participation should extend beyond the EU, including the UK, Switzerland, Israel, and Ukraine.
Likewise, it is necessary to expand significantly the European Investment Fund which, in 2024, committed to €3.1 billion in high-tech innovation (ETCI) and €7.3 billion in equity financing (of which only €175 million for defence) to support later-stage start-ups through scale-up finance.
A Bayh–Dole-style framework would allow public institutions to retain and license intellectual property from publicly funded research, amplifying returns and translating discoveries into technological leadership across the whole continent (as opposed to only Denmark and Germany, which adopted a version of the American legislative framework). This echoes Vannevar Bush’s insight: public inventions should be patented to ensure disclosure, diffusion, and cumulative progress across sectors, including defence.
Addressing objections
First, security needs are immediate, but urgency justifies targeted procurement flexibility, not permanent exemptions for wages and imported hardware or for current spending creatively relabelled as defence (see German Council of Economic Experts 2025).
Second, innovation spending is hard to monitor, yet R&D is highly auditable — projects are registered, peer-reviewed, and often co-funded under the Horizon Europe framework.
Third, revising fiscal rules is politically difficult, but the Stability and Growth Pact (SGP) already recognises that not all debt is equal (Janeba and Larch 2025). An innovation exemption is a logical next step and would better equip the EU for future crises, including pandemics.
From loophole to leverage: a call for action
Europe stands at a crossroads. It can maintain fiscal rules that divert borrowing into short-lived consumption and potentially obsolescent equipment — or it can redesign its fiscal architecture around innovation: the ideas, technologies, and institutions that drive long-term prosperity and strategic autonomy.
The post-1945 US experience is clear: placing science and innovation at the heart of national strategy transforms productive capacity for generations. Europe must now choose the same path — replacing upside-down exemptions with rules that reward public investment in knowledge, empower universities and research institutes, and catalyse private-sector innovation across the continent. The choice is stark: continue subsidising technological dependence or build Europe’s technological future.
References
Aghion, P and P Howitt (1992), “A Model of Growth Through Creative Destruction”, Econometrica 60(2): 323-351.
Antolin-Díaz J and P Surico (2025), “The Long-Run Effects of Government Spending”, American Economic Review 115(7): 2376-2413.
Bayh–Dole Act (1980), “U.S. Public Law governing ownership and licensing of publicly funded research”.
Bush, V (1945), Science: The Endless Frontier, U.S. Government Printing Office.
Draghi, M (2024), The Future of European Competitiveness: A Report for the European Commission.
European Defence Agency (2025), “European Defence Agency data 2024-2025”.
Fieldhouse, AJ and K Mertens (2025), “The Returns to Government R&D: Evidence from US Appropriations Shocks”, Working Paper.
Gazzani, A, J Martinez, F Natoli and P Surico (2025a), “The Public Origins of American Innovation”, CEPR Discussion Paper 20788.
Gazzani, A, J Martinez, F Natoli and P Surico (2025b), “Public money, private innovation: How government funding built—and sustains—America’s technological leadership”, VoxEU.org, 18 November.
German Council of Economic Experts (2025), Jahresgutachten “Perspektiven für morgen schaffen, Chancen nicht verspielen”.
Gross, D and B Sampat (2025a), “America, Jump-Started: World War II R&D and the Takeoff of the US Innovation System”, American Economic Review 113(12): 3323-3356.
Gross, D and B Sampat (2025b), “New data, old debates: US government-funded R&D and patent policy”, VoxEU.org, 17 February.
Janeba, E and M Larch (2025), “The European Union’s new fiscal rules: A fine line between brilliant masterpiece and another chapter of déjà vu”, VoxEU.org, 14 November.
Mejino-López, J and G Wolff (2025), “Europe’s dependence on US foreign military sales and what to do about it”, Bruegel Brief, 13 October.
Parry, C (2025), “Start-up Financing, Entry and Innovation”, Cambridge University mimeo.
This article was originally published on VoxEU.org.
