Debt and precarious stagnation in the EU and Germany

The direction of the world economy is unclear. Geopolitical crises may disrupt supply chains (wars in various parts of the world), financial overhangs need resolute answers (public debts and interest-rate manipulation) and self-inflicted wounds (United States President Donald Trump’s preference for confrontational approaches, with occasional second thoughts) sometimes generate unpleasant surprises.

Previously, governments responded to economic crises by resorting to public-spending increases and loosening monetary policy to boost demand and production. These efforts usually failed to achieve satisfactory results, but markets observed that despite much scaremongering, no major catastrophe occurred. The public believed that major reforms could be safely delayed, or even avoided altogether. However, after the Covid-19 mess, “temporary inflation” and the beginning of the “green transition,” perceptions have perhaps changed.

The public has now lost faith in traditional muddling through and demands drastic changes.

 

This report focuses on Europe, where the economic situation has worsened considerably in recent years. Several countries on the old continent have become more vulnerable to shocks, and imbalances have piled up. Moreover, leaders have demonstrated an inability or unwillingness to address structural problems, yet they are all too eager to haughtily break their electoral promises, swim with the tide and gather consensus through frantic lawmaking in the name of emergencies, fairness and social justice.

Germany is the main example of Europe’s economic struggles, but it is not the only one. Not surprisingly, the public has now lost faith in traditional muddling through and demands drastic changes. Room for maneuver is limited. Once again, Germany’s recent political developments are emblematic of the trend and are observed with some apprehension. How will the policymakers react?

European public finances meet fiscal profligacy

Figures show that European public debt in terms of gross domestic product (GDP) is high: On average, it stands at 81 percent for the European Union and 87 percent for the euro area. While public debt is 62 percent of GDP in Germany, it reaches 113 percent for France and a staggering 135 percent for Italy. Those who believe in fiscal constitutions surely remember that – historically – public debt can get out of control and spark a crisis even when it reaches 60 percent of GDP, which is more or less the average debt-to-GDP ratio that currently characterizes the somewhat more fiscally prudent EU states of Poland, Hungary and the Czech Republic.

Soon, the new chancellor, Friedrich Merz, is likely to engage in fiscal profligacy, to spur domestic aggregate demand as he seeks to build parliamentary consensus.

 

Average national government spending in the European bloc amounts to about 49 percent of GDP, reaching a record 57 percent in France; meaning that government spending alone is responsible for well over half of the entire French economy. All the large EU countries exceed the average of the bloc. Taxation is also heavy, yet still not enough to cover runaway expenditure. Thus, many countries are burdened with considerable budget deficits. Although the average EU budget deficit is “only” slightly above 3 percent, Poland and France are dramatically higher (6.6 percent and 5.8 percent of GDP, respectively). In contrast, EU states with below-average deficits last year included Germany at 2.8 percent of GDP and the Czech budget gap at 2.2 percent.

Most European countries cannot afford to engage in even more debt-financed or tax-financed public expenditure. Germany has been an exception, but it will not be for long. Soon, the new chancellor, Friedrich Merz, is likely to engage in fiscal profligacy, to spur domestic aggregate demand as he seeks to build parliamentary consensus. By doing so, his government will violate the country’s erstwhile public-finance rules, but he probably will do it anyway. Just because Chancellor Merz opposes common European debt issuance for defense does not mean that he is against European debt of any sort.

Reasons to worry about the public purse

EU member states have cause to worry, for three reasons. First, in most countries, the public and policymakers have become cognizant that the eventual result of increased public expenditure yields little to no benefits for growth. Instead, it usually leads to higher taxes and lower disposable incomes (what remains in households’ pockets). Indeed, people are realizing that a rise in public expenditure results in additional state and local restrictions, monitoring and hassles. Ultimately, it becomes a drag on economic growth.

Although there is no consensus on where to start cutting public spending, it is also clear that there is an urgent need to contain it. It took decades to develop this awareness. If Germany were to break or bend the rules in the near future, European legislators would find themselves in a difficult position and nobody could predict how the electorate would react.

Second, if Berlin chooses to engage in debt-financed expenditure but fails to kickstart growth − which is most likely − Germany will surely become financially weaker. Interest rates on government bonds would rise across the continent and so too would the cost of debt servicing. Fiscal discipline would likely break down in several countries, such as Italy, and attempts to reduce budgetary imbalances would be in vain (for instance, in France).

Finally, German profligacy, should it materialize, would put Brussels in a difficult position. The EU’s attempts to gain fiscal autonomy and replace the discretionary power of national governments to tax and spend have always depended on support from Germany and the consent of France. Yet, in both countries, today’s political climate has solidified opposition to the ambitions of the EU bureaucracy. In particular, the supposed advantages of the bloc’s debt being implicitly backed by German guarantees have become less evident.

In the past, markets were ready to believe that Germany could become the financial pillar of an increasingly centralized EU. However, the prospect of the EU having to come to the rescue of a weaker German treasury would send jitters across governments and financial markets while badly shaking the euro.

This report was originally published here: https://www.gisreportsonline.com/r/eu-germany-fiscal-risks/