Defence, debt and discipline: navigating fiscal constraints in CEE/SEE

How constitutional debt brakes and EU rules are shaping defence spending strategies across the region

Security demands and fiscal rules: why this matters now

Mounting defence spending obligations, strict constitutional debt ceilings and eurozone fiscal rules are colliding with fragile political coalitions in CEE/SEE. Governments face hard trade-offs: meet NATO and EU security demands or maintain fiscal credibility in the eyes of markets and rating agencies. The way these states navigate this tension will shape investor confidence, regional stability and the long-term credibility of EU fiscal governance.

1. Rising tensions, rising spending, rising debt

The intersection of defence spending and fiscal laws has become one of the most pressing challenges in CEE/SEE. As NATO allies demand higher military commitments and regional security pressures mount, governments must reconcile constitutional debt rules with urgent rearmament needs.

Germany’s March 2025 constitutional amendment to exempt certain defence expenditures from its debt brake has set an important precedent. Across the region, governments are already experimenting with legal workarounds such as off-budget funds, state-owned conduits, broad emergency clauses and reclassification of expenditure. These approaches can buy time but carry risks – from domestic legal/political challenges and EU scrutiny to reputational damage in the capital markets.

This briefing note maps fiscal rules in the region, reviews legal workarounds, considers legal and market risks and draws lessons from sovereign debt history.

2. The origins of taxation and debt: financing war and security

Throughout history, governments’ primary fiscal challenge has been funding military campaigns. Many of the modern tools of public finance – taxation, borrowing and debt markets – were developed as responses to defence needs. In Ancient Rome, extraordinary wartime taxes (tributum) were levied to raise funds for campaigns. These were discontinued in peacetime, showing the link between war and revenue. Kings in medieval Europe often negotiated new taxes with estates or parliaments to fund wars. In England, the Crown’s demands for military finance led to requirements in Magna Carta for parliamentary consent for taxation. The rise of standing armies in the 16th–17th centuries forced rulers to move from ad hoc levies to regularised taxation systems, including excise and customs duties.

The birth of sovereign debt markets saw Venice, Genoa and later the Dutch Republic pioneering government borrowing to fund defence. England institutionalised this with the creation of the Bank of England in 1694 to finance the Nine Years’ War against France. During the Napoleonic wars, Britain’s extensive use of debt markets – sustained by parliamentary credibility – enabled it to outspend France and helped to establish a model of “credibility plus markets equals military advantage”. Spain’s frequent defaults in the 16th and 17th centuries dented its credibility but crucially did not prevent it from continuing to borrow. Investors demanded higher yields, but the persistent ability to access credit underlined that even serial defaulters could mobilise resources if geopolitical weight and expectations of future revenue were strong enough. The World Wars of the 20th century witnessed mass conscription being matched by mass fiscal mobilisation – war bonds, new taxes and rationing systems. The US Liberty Bonds, for instance, democratised public debt ownership as a patriotic duty.

3. NATO obligations and the challenge to the post-1945 order

The “Elephant in the room”, namely the challenges presented to the post-1945 consensus by so-called “bulldozer politics” is addressed in The Munich Security Report (the “MSR”), which was published in February 2026 ahead of the Munich Security Conference. Tobias Bunde and Sophie Eisentraut, in their introduction to the MSR, note that even those who criticise the “destructive but creative style” of the proponents of a more transactional world order, concede that it has “led to some remarkable developments” – notably NATO leaders agreeing to a five percent defence spending target by 2035.

For NATO members in CEE/SEE, especially those along the Alliance’s eastern flank, increased defence spending is a response to a clear and present danger. The 2 percent of GDP benchmark has hardened into a floor: Poland’s defence spending has risen from 1.86 percent in 2025 to 4.48 percent in 2025, the Baltic states are already moving well beyond 3 percent and in Lithuania’s case in 2025 4 percent.

4. Eurozone fiscal rules: an additional layer of constraint

For CEE/SEE countries in the euro area as well as those aspiring to join, the EU Stability and Growth Pact (“SGP”) requirements and the new EU fiscal framework impose an additional layer of fiscal constraint. These rules operate across three key dimensions:

• Deficit limits: Member states must keep deficits below 3 percent of GDP, unless an excessive deficit procedure (“EDP“) is triggered.
• Debt paths: Debt above 60 percent of GDP must fall along an agreed trajectory, limiting fiscal flexibility.
• Commission oversight: Unlike domestic constitutional rules, eurozone members face direct enforcement through the European Commission and the Council.

This means that CEE/SEE eurozone members must navigate three overlapping constraints: constitutional debt brakes (if applicable), EU fiscal rules and investor scrutiny. Off-budget manoeuvres that might work outside the eurozone face far greater risk of reclassification in countries where the euro has been adopted.

5. Debt brakes and fiscal constitutions in CEE/SEE

In response to past financial crises, many states in the region have strict fiscal rules to ensure convergence and credibility. In Poland, the constitutional debt rule caps debt at 60 percent of GDP. Slovakian law imposes a debt brake with escalating sanctions from 50 percent of GDP upwards. The statutory framework in the Czech Republic provides for corrective mechanisms to trigger if public debt rises above 55 percent of GDP. The Hungarian constitution imposes a ceiling of 50 percent of GDP, with narrow exceptions. Bulgaria has statutory fiscal rules in place to cap public debt at 60 percent of GDP.

6. Legal and financial workarounds: CEE/SEE governments under pressure

Governments across the region are testing fiscal engineering to balance defence needs with fiscal rules. Poland’s Armed Forces Support Fund, an off-budget fund, bypasses the 60 percent ceiling. In Hungary, state-owned conduits are used to channel funds through public banks and enterprises. Other regional players have sought to develop emergency clauses, which invoke extraordinary circumstances (though the risk is that, if challenged, courts may interpret these narrowly). Eurozone members have sought flexibility under the new EU fiscal framework, potentially arguing that defence constitutes a European public good.

7. Historical precedents: debt, defence and instability

Historical experience demonstrates that the balance between sovereign debt and defence spending has long influenced national stability. In the 1980s, Poland’s heavy borrowing from the previous decade’s expansionist economic policies and the military expenditure associated with the introduction of martial law contributed to sovereign default and further stoked growing political unrest. Pre-revolutionary Iran in the 1960s and 1970s pursued high defence spending, seemingly in denial of the so-called “guns versus butter” rule, which historians have argued contributed to the internal tensions that ultimately led to the demise of the Shah. Argentina in the late 1970s became heavily indebted under U.S. dollar-denominated debt instruments, a combination of increased borrowing costs (associated with the “Volcker shock” in the United States), capital flight, a deepening recession and the misguided invasion of the Falkland Islands created a perfect storm, which eventually lead to the military junta’s collapse in 1983.

Earlier precedents reinforce this pattern. In the late eighteenth century, France’s mounting military expenditures in the lead-up to the Revolutionary Wars, combined with a rigid fiscal system and unsustainable debt levels, contributed to the collapse of royal authority and the onset of revolution. These examples illustrate a broader principle: both excessive military and state expenditure and neglect of national security can destabilise states. The challenge of balancing fiscal discipline with strategic preparedness remains as pressing today as it has ever been.

8. Lessons for CEE/SEE today

The historical record highlights several enduring lessons that remain highly relevant to contemporary fiscal and security challenges. Military necessity has often driven fiscal innovation: from Roman wartime levies to British war bonds, governments have developed new financial instruments when survival was at stake. Credibility has consistently proven decisive; states with strong institutions, such as Britain or the Dutch Republic, were able to borrow at lower cost, while those lacking institutional strength, such as Argentina and Poland in the 1980s, faced default or instability.

Importantly, defaults have not always closed access to credit markets. In the late 16^th century, the Spain of King Philip II had a long history of sovereign defaults, demonstrating that even serial defaulters could continue to borrow, albeit at higher cost and with reputational penalties. Moreover, extraordinary financing mechanisms introduced during wartime often evolve into permanent institutions – including standing taxation regimes, central banks and formalised debt markets.

Investor trust, therefore, emerges as a strategic asset. Just as Britain’s fiscal credibility during the Napoleonic Wars enabled it to finance sustained military campaigns, today’s states with stronger reputations – particularly in Central and Eastern Europe – are likely to secure cheaper defence financing than those reliant on opaque or ad hoc arrangements.

9. Legal challenges, EU scrutiny and market risks

While fiscal innovation can offer governments greater flexibility in funding defence and security priorities, it carries significant risks – particularly in the context of Central and Eastern Europe. These risks are threefold.

First, legal challenges may arise when creative financing mechanisms stretch constitutional boundaries. Courts in countries such as Poland have previously been asked to review unconventional interpretations of budgetary authority. Whilst the ability to challenge the legislature when it appears to be circumventing (or seeking to circumvent) the law is a fundamental aspect of the rule of law, legal challenges to legislation may lead to uncertainty and have a tendency to delay the implementation of the laws/mechanisms being questioned.

Second, European Union oversight mechanisms pose a regulatory risk. Institutions such as Eurostat and the European Commission have the authority to reclassify off-budget entities or financing vehicles, potentially undermining the credibility of fiscal strategies and forcing their inclusion in headline debt figures.

Third, markets tend to treat off-balance-sheet borrowing as de facto sovereign obligations. Investors may respond by demanding higher yields or limiting access to capital, particularly when transparency is lacking. In this context, fiscal credibility becomes a strategic asset, and opaque workarounds may ultimately prove more costly than conventional borrowing.

10. Implications for investors and businesses

Sovereign debt issuance across Central and Eastern Europe is expected to rise significantly, with a growing share tied to defence spending. Much of this may occur through unconventional channels, including off-budget entities and bespoke financing vehicles. However, such innovation carries legal and regulatory risks. Constitutional courts may challenge creative interpretations of budgetary authority and EU institutions such as Eurostat or the European Commission may reclassify off-budget structures, retroactively increasing reported debt ratios.

Country-level differentiation is becoming more pronounced. Poland and Hungary, operating outside the eurozone, retain greater fiscal manoeuvrability. In contrast, NATO members within the eurozone such as Slovakia, Croatia and Bulgaria are subject to stricter EU rules and therefore have less flexibility in deploying off-balance-sheet financing.

Meanwhile, the defence industry is poised for expansion across the region, driven by rising demand and geopolitical urgency. Yet procurement timelines may be delayed by fiscal wrangling, particularly where legal uncertainty or market scepticism complicates funding strategies.

11. Safety in numbers

The European Union’s Security Action for Europe program (“SAFE“), which was launched in May 2025 will offer up to €150 billion in low‑cost, long‑term EU‑backed loans to member states to support major defence investments. Funding will prioritise joint procurement projects involving multiple EU countries (and potentially Ukraine or EEA‑EFTA partners) to strengthen Europe’s defence industry and reduce fragmentation. Given current geopolitical pressures, temporary support for individual national procurements is also allowed. Because the loans are financed through EU‑level borrowing, participating countries benefit from the EU’s strong credit rating and favourable loan terms.

The first SAFE funding round included almost €4 billion of loans going to Bulgaria and €16 billion of loans to Romania. The second round of funding under SAFE was announced on 17 February 2026 – just after the end of the Munich Security Conference – and saw Poland securing a €44 billion loan to fund defence needs and the Baltic states receiving a combined total of €12 billion in defence related financing.

A significant further development, also announced on 17 February 2026, is the inclusion of Canada under the umbrella of SAFE. While Canada will be able to access funding under the programme, Canadian companies will also be eligible to participate in procurement programmes associated with SAFE financings. As Tobias Bunde and Sophie Eisentraut note in their introduction to the MSR “effectively pushing back against the demolition men requires much more political courage and innovative thought” – SAFE, as well as the expansion to include Canada, seems to tick both boxes.

12. Strategic outlook: where to watch most closely

The legal and institutional landscape across Central and Eastern Europe presents varying degrees of constraint on defence-related fiscal innovation. NATO members with eurozone obligations and constitutionally enshrined debt brakes, may face the sharpest legal scrutiny. Attempt to circumvent fiscal limits through off-budget mechanisms may provoke domestic legal questioning as well as EU-level challenges. Poland, while outside the eurozone, has increasingly relied on conduits and extra-budgetary structures to finance defence expansion. This approach needs to avoid compromises in terms of transparency and parliamentary oversight – particularly because of the challenges presented by “cohabitation” (when the government and president do not come from the same political fraction). Slovakia, Croatia and Bulgaria, all NATO and eurozone members, operate under stricter EU fiscal rules and have limited room for manoeuvre. Their ability to innovate around defence financing is constrained by the need to maintain compliance with European budgetary standards and reporting obligations. The SAFE program indicates a willingness on the part of the EU to think outside the box (or perhaps to think inside a differently shaped box) when it comes to the pressing need for increased military and defence spending. These variations underscore the importance of institutional design and legal clarity in shaping the feasibility and sustainability of defence financing strategies.