Europe is set to increase spending on defence, infrastructure and the green transition even as the cost of borrowing climbs across the bloc.

Euro‑area governments are already feeling the pressure. In France, debt‑service payments now absorb roughly six per cent of total revenue, double the share recorded in 2019. German bund yields have risen to their highest level since 2011, and the country's 2026 federal budget will require almost €180 billion of new borrowing, on top of a €500 billion infrastructure fund created last year.

Bond issuance is at a record pace, but the surge is not simply a matter of more spending. A combination of external shocks, policy choices and structural market shifts is pushing yields higher, which in turn raises the price of every euro of new investment.

External shocks lift inflation and demand higher returns

The war in Iran has sent energy prices soaring, lifting euro‑zone inflation to 3.3 per cent in August, the highest level in almost three years. Investors therefore demand a larger risk premium on sovereign bonds. By June, borrowing costs across the euro area had already risen by about half a percentage point since the conflict began.

At the same time, the European Central Bank (ECB) has stopped reinvesting the proceeds of its massive pandemic‑era bond purchases. The central bank will therefore withdraw roughly €384 billion of liquidity from the market this year. ECB chief economist Isabel Schnabel estimates that this alone has added around 0.6 percentage points to borrowing costs.

US tech bonds compete for the same investors

Across the Atlantic, a boom in artificial‑intelligence‑related financing is reshaping the European bond market. US technology giants are increasingly issuing long‑dated, highly‑rated corporate bonds in Europe to tap the continent's deep pool of capital. Because these securities vie for the same investors who traditionally buy government debt, the ECB warned that they could further push up yields.

Pension reforms shrink the pool of long‑term funding

Europe's own pension policies are also altering demand for sovereign bonds. Under the EU Commission's Savings and Investments Union, a larger share of retirement savings is being steered into equities, which reduces the amount of capital available for government debt.

In the Netherlands, a shift of roughly €1.5 trillion of pension assets from a defined‑benefit to a defined‑contribution system is expected to cut demand for long‑dated bonds. Those securities are crucial for financing large‑scale projects such as railways and power‑grid upgrades, which rely on stable, low‑cost funding over many years.

Higher rates hit climate‑friendly investment

The ECB is poised to raise its policy rate again next week, likely to 2.5 per cent. Higher rates increase the cost of capital for projects that depend heavily on debt financing. Renewable‑energy schemes are especially vulnerable because they require large upfront outlays, up to 80 per cent of total costs are paid before any revenue is generated.

When the ECB began tightening in 2022, raising rates by 4.5 percentage points, investment in new offshore wind projects across Europe virtually stalled. Four economists writing for the European Parliament warned in June that indiscriminate tightening could push the continent back toward fossil‑fuel dependence. They called for a targeted approach that shields clean‑tech financing from the full force of rate hikes.

Calls for joint EU debt to fund the green agenda

EU green‑transition commissioner Teresa Ribera has advocated for a joint EU debt instrument to finance climate‑proofing measures. However, rising borrowing costs and the growing share of budgets devoted to debt service make such a scheme increasingly difficult to launch.

Bruegel, a Brussels‑based think‑tank, has also urged the ECB to slow the reduction of its bond portfolio, arguing that a rapid withdrawal of liquidity could choke the financing of long‑term public‑good projects.

Europe's ambition to spend more on defence, infrastructure and the climate therefore collides with a financial environment that is becoming less forgiving. Higher yields raise the price of every euro borrowed, while pension reforms and competition from US corporate bonds shrink the pool of long‑dated funding that governments rely on.

For workers and households, the stakes are clear. If borrowing costs continue to climb, governments may be forced to cut back on public investment or raise taxes, both of which could erode living standards. At the same time, delayed or under‑funded green projects risk slowing the transition to a low‑carbon economy, potentially increasing energy prices and undermining climate goals.

Policymakers now face a delicate balancing act: they must secure affordable financing for long‑term projects while containing inflation and maintaining fiscal stability. The choices made in the coming months will shape Europe's ability to meet its strategic objectives without passing undue burdens onto ordinary citizens.