Scope: Greece among the “few” in Europe with positive prospects – Economic Postman

Countries that experienced the severity of the fiscal crisis in the past decade, namely Greece, Ireland, Portugal, Spain and Cyprus, and have implemented significant reforms have more favorable macroeconomic trajectories. The rest of the Eurozone are subject to great fiscal pressure.

That’s what Scope says in its latest note on what it calls the “fiscal test” facing the Eurozone, with some credit ratings under pressure as weaker governments struggle to implement medium-term fiscal plans.

Europe: Sun, sea and exports strengthen the success story of the South

The eurozone is facing fiscal challenges

According to Scope, Europe faces a challenging macroeconomic environment in the coming years, with low growth, higher interest payments and significant upward pressure on social, environmental and defense spending. Recognizing these fiscal constraints should lead to significant fiscal compromises.

While public debt reduction is possible, even for over-indebted states, based on historical fiscal adjustments, weak governments struggling to implement coherent medium-term fiscal plans are putting pressure on the credit ratings of some euro area states.

The macroeconomic outlook remains subdued

While the EU has demonstrated its ability to respond and recover, as it did with the pandemic and the energy crisis, Scope expects moderate economic growth of around 1% in 2024 and 1.8% in 2025. The increase in long-term growth of Europe’s potential – estimated at 1.4% – remains critical. Accelerating the implementation of the Next Generation EU (NGEU) plan, both in reforms and investments, would help.

Also, faster progress in the capital markets union, launched in 2015, to facilitate cross-border savings and investment and thus better allocation of resources across Europe would also support growth.

Digital transformation and innovations such as artificial intelligence (AI) can also help boost productivity. Europe is leading the way in developing regulatory frameworks for the sector, but risks falling behind other major economies in reaping the benefits of AI-related digital innovations, Scope points out.

Europe may also decide to open its borders more systematically to address labor shortages, but current political dynamics make that unlikely.

Likewise, reforming Germany’s “debt brake” rule to allow for an investment-led fiscal stimulus ahead of the 2025 federal election looks unlikely.

While such structural reforms could boost Europe’s growth prospects, their rapid and full implementation today appears unlikely, supporting the baseline scenario of only moderate growth, Scope reports.

The debt problem

In addition, Europe is facing structurally higher levels of public debt following the pandemic and the energy crisis. Public debt higher due to aggregate and fiscal disparities between euro area states widened after the crises.

For example, the debt ratio gap between Germany and France increased from 38 percentage points in 2019 to almost 50 percentage points, in contrast to the almost zero gap between 1992, when the Maastricht Treaty was signed, and 2012, the peak of crisis in the euro area.

This matters because different levels of government debt imply different capacities to respond to the next shock, Scope explains.

Furthermore, divergent fiscal positions may also complicate discussions about future solidarity and fiscal risk sharing, especially in the case of country rather than region-wide shocks.

Finally, Scope expects interest rates to be permanently higher compared to pre-Covid years, even when central banks ease rates starting later this year. Interest payments will continue to rise as government debt issued at lower interest rates before and during the pandemic matures and is now refinanced at higher interest rates. Italy, Germany, France and Spain will collectively pay almost €170bn more in interest in 2028 compared to 2020.

While net interest payments as a percentage of revenue will remain below the previous peak, expected higher interest payments will squeeze fiscal space, forcing governments to cut spending elsewhere, raise taxes or borrow more.

Spending on welfare, environment and defense is increasing

The three challenges – moderate growth, high public debt and rising interest payments – coincide with pressures for higher spending and investment, exacerbated by demographic changes and a shrinking working population, Scope adds.

Together, these trends will strain fiscal budgets by about 1.5 bp. of GDP, on average, in the coming years. Similarly, the significant investment needs to achieve carbon neutrality by 2050 are estimated at around 0.5% to 1% of GDP per year for the public sector alone, based on European Commission data.

Europe also faces large investment needs to meet NATO defense goals, in some cases around 0.5% to 1.0% of GDP, in addition to financing Ukraine.

In addition, industrial policies to boost domestic production for economic autonomy and national security will also squeeze European state budgets, through lower taxes and/or more generous subsidies.

Overall, Europe’s set policy priorities imply higher spending and investment needs of around 3-4% of GDP at a time when growth is moderate at best.

Major fiscal compromises are coming

The resulting financial constraints should lead to difficult trade-offs between reforming generous welfare systems, financing Europe’s “green ambitions”, meeting defense spending targets or raising taxes, Scope reckons.

How governments prioritize here will depend not only on their specific circumstances but also on the degree of European solidarity.

For example, the Baltic States, Central and Eastern European countries and Finland are unlikely to reduce defence, while for countries where perceived threats are lower, such as Spain, defense is likely to take a backseat.

Similarly, countries with very high tax burdens – such as France and Belgium – are unlikely to raise taxes further. Like Germany and Austria, these two countries may consider rebalancing tax structures beyond labor income, which is becoming increasingly scarce, towards capital, property and environmental factors.

These fiscal pressures may also accelerate the debate about which spending should remain at the national level and which spending should be shifted to the European level. The past years have shown that health, energy and defense are European as well as national public goods.

Financial risks

At the same time, fiscal risks are likely to increase in the coming years, with Scope concerned about highly indebted countries with large primary deficits and governments operating in a highly fragmented political environment. Countries previously affected by the crisis, such as Greece, Ireland, Portugal, Spain and Cyprus, have implemented significant reforms under EU financial assistance programmes, resulting in more favorable macroeconomic trajectories.

However, not all euro area countries have used the recent years of loose monetary policy so effectively to address the fiscal challenges they face.

For example, France and Belgium, which have a negative outlook, risk not fully recognizing their economic constraints. Government plans aimed only at stabilizing public debt at current elevated ratios suggest that debt will continue to rise whenever the next crisis occurs, Scope concludes.