Some of Europe’s most indebted governments are heading for a painful reckoning this year as their ambitions to cut down on borrowing collide with political reality.
After years of a no-limits approach to spending when the continent navigated pandemic shutdowns and surging energy prices, 2024 was meant to mark a milestone in repairing public finances from France to the UK.
But while most will make progress reining in deficits by phasing out energy support measures, pressures from both new and existing commitments, and the impact of rising interest rates, are now set to keep national debt high or even rising in much of the region. Italy’s borrowings, for example, could soon exceed 140 per cent of output again.
That will leave some governments stuck between irking voters by cutting spending or increasing taxes, or else risking that investors might notice their lack of action. The backdrop of a politically sensitive year, with elections taking place for the European Parliament and probably for Westminster in the UK, adds to the challenge.
“The economic situation in Europe right now is already very prone to nourishing populist rhetoric,” said Famke Krumbmüller, EMEIA leader of geostrategy at EY. “When these countries go into an additional round of fiscal consolidation, that will just further increase the dynamic.”
Scrutiny of the region’s less healthy public finances is intensifying. Late on Friday for example, Fitch Ratings observed that France’s aim to bring its deficit down to 3 per cent of gross domestic product by 2027 “will be difficult to achieve.”
The International Monetary Fund’s forecasts this month showed just how stark the change in outlook has become. While deficits are projected to narrow, both France and Italy are now poised to take on more debt, as is the UK.
Higher interest costs and anaemic growth are among the reasons for the worsened outlook for public finances, but policy choices also matter.
Italy, for example, is stuck with the legacy of a pandemic-era tax break for home renovations known as the “superbonus” that will bloat its public finances for years. Coalition political wrangling also resulted in a loosening of its fiscal stance in 2023.
In France, President Emmanuel Macron has stopped short of attempting new legislation for deeper spending cuts that some opposition lawmakers are calling for. Presenting a revised budget bill to parliament would likely trigger a no-confidence vote that could bring down his government.
Across the European Union, the prospect of a significant breakthrough for far-right parties in June’s region-wide vote is raising pressure to delay or sugarcoat spending cuts. The UK faces similar challenges as a looming general election ties the hands of the Conservative government.
There could be scope for some action when such votes are out the way. Italy’s economic forecasts this month didn’t incorporate potential legislation by Premier Giorgia Meloni’s government, possibly hinting that some attempt at fiscal repair could follow.
The bigger longer-term problem everywhere though is that there seems little appetite or impetus among citizens to trim budgets, nor any consensus on the matter.
According to the European Commission’s latest Eurobarometer survey, voters’ top priority is fighting poverty and exclusion — problems that often cost money to address — followed by supporting the economy and creating new jobs.
In the UK, polling by YouGov earlier this month showed an almost equal portion of respondents directly disagreeing with each other on whether the UK does or doesn’t tax too much and spend excessively on services.
“Building popular support for bringing debt down looks challenging,” said Colin Ellis, a global credit strategist at Moody’s Ratings. “While we expect growth to pick up in Europe this year, debt dynamics still look problematic for a number of countries.”
What has bought time for Europe’s current leaders is a benign backdrop in financial markets, with the yield of Italian bonds over German equivalents — a key measure of risk in the region — having dropped to a two-year low earlier this year.
But in the longer term, multiple pressures will continue to squeeze public finances and load political pressure on European governments and institutions.
One is the need to devote resources to defence at a time when the US commitment to defend Europe seems to be wavering. Funding the green transition is another, and ageing populations will also push up pension and health bills.
Signs of tension are already emerging, with Macron last week calling for a change of paradigm in EU rules that includes reopening a thorny debate over the mandate of the European Central Bank — whose unprecedented tightening has hugely increased France’s financing costs.
The tensions will also come to bear on the European Commission, which is in charge of nudging countries to repair their public finances. Its officials are set to release growth and debt forecasts for the region in a couple of weeks, followed by a judgment on how stringent they should treat deviation from their rule capping deficits at 3 per cent.
As officials also know only too well from the region’s sovereign debt crisis of the past decade, getting the balance right there in enforcing discipline isn’t politically easy.
While the onus is on Brussels to punish fiscal recalcitrance, austerity could brake what precious little growth Europe can achieve. Allianz economists already expect fiscal consolidation to shave half a percentage point off European economic expansion in both 2024 to 2025.
“It’s a political and economic bomb for Europe, especially as the US doesn’t seem to be thinking about consolidating any time soon and because China is only delivering growth because of fiscal stimulus,” Allianz Chief Economist Ludovic Subran said. “The long tail of two major shocks is haunting policymakers and pushing them into potential policy mistakes.”
