The next leaders of Europe face crushing debts
European governments are facing a challenging situation as they take office. They are elected with a strong mandate for change, but have limited resources to implement it.
The level of public debt is currently at its highest point in decades on both sides of the English Channel, coinciding with the ongoing parliamentary elections this week. In both France and the U.K., government spending and budget deficits as a share of gross domestic product have risen considerably since before the pandemic. The economy continues to show weak growth, with borrowing costs increasing and a growing need for government funding in various areas, such as defense and pensions.
Fiscal restraint, according to economists, will be necessary. This could involve reducing spending or increasing taxes. However, politicians have failed to adequately inform the public about this. In contrast, they have indicated ambitious new spending proposals.
In France, the far-right National Rally is projected to secure the majority of seats in parliament in Sunday’s election. They have put forward proposals for significant tax cuts and the reversal of President Emmanuel Macron’s controversial decision to raise the state pension age. However, it is worth noting that party officials have recently scaled back some of these promises. The New Popular Front, a left-wing alliance that is projected to secure the second position, has a highly ambitious agenda. It involves implementing price freezes and a significant rise in the minimum wage, which would necessitate increased subsidies and salaries while reducing tax revenue.
None of the French political parties have addressed the issue of reducing the public deficit, which currently stands at approximately 5% of GDP. This deficit has led to disciplinary action being taken by the European Union. French government-bond yields have experienced a significant increase in recent weeks due to investor concerns over the possibility of increased French borrowing. In May, Standard & Poor’s downgraded France’s sovereign debt rating to AA-.
In the U.K., the Labour Party, which won a significant majority in the election, has indicated its intention to increase spending on public services, such as the National Health Service, although its specific plans have been relatively modest thus far. The Institute for Fiscal Studies, a London think tank, recently criticized all major parties, including Labour, for avoiding difficult decisions in their manifestos.
It appears that the growth outlook is rather underwhelming and the burden of debt interest is expected to persist at elevated levels. “The combination of factors is appearing more unfavorable than in any previous parliament in the U.K. since World War II,” stated Isabel Stockton, a senior research economist at the IFS.
The U.K.’s public debt has seen a significant rise, reaching 104% of gross domestic product this year. This marks a notable increase from 86% in 2019 and 43% in 2007. France’s national debt has experienced a significant increase, reaching 112% of GDP. This is a notable rise from 97% in 2019 and 65% in 2007, as reported by the International Monetary Fund.
Public budget deficits in major advanced economies are currently 3 percentage points higher than pre-pandemic levels, as reported by Capital Economics. According to Neil Shearing, the firm’s chief economist, the rise in interest payments and non-pandemic related spending are contributing factors to this. “There is limited potential for significant fiscal expansions,” he stated.
Germany, typically known for its careful fiscal management, has experienced a shift from budget surpluses to significant deficits in the 2010s. Following extensive negotiations, Chancellor Olaf Scholz’s three-way coalition announced on Friday that they have reached a budget agreement for next year. The deal adhered to the country’s stringent borrowing regulations while also including provisions to stimulate sluggish economic growth and enhance military expenditures.
The U.S. situation is more concerning: its public debt has increased to 123% of GDP from 108% in 2019, as reported by the IMF’s comprehensive measure. The publicly held federal debt has increased from 78% to 97% over the same period. However, both Donald Trump and Joe Biden, the presumed candidates for their respective parties, have not made reducing it a priority. Additionally, there seems to be a lack of political pressure to take action on this matter.
According to the IMF, it is projected that the U.S. deficit will be approximately 6.5% of GDP this year, which would be on par with Japan as the highest among major industrial economies. However, the United States possesses several significant advantages compared to Europe. These include strong economic growth, more favorable demographics, and the potential to increase taxes that are currently low when compared to global standards.
In an uncertain world, investors are more inclined to purchase the U.S.’s bonds due to the reserve status of the dollar. “The U.S. manages to sustain fiscal policies that would be deemed unsustainable by others,” commented Holger Schmieding, the chief economist at Berenberg Bank.
During the aftermath of World War II, governments successfully reduced the high public debt relative to GDP through a combination of robust economic growth and significant cuts in military spending. Over the years, military spending in the U.S. has experienced a significant decline, dropping from approximately 16% of GDP in the early 1950s to less than 4% in present times. Similarly, in the U.K., military spending has also seen a substantial decrease, falling from over 10% to around 2%.
It is challenging to determine which aspect of government spending would decrease in this situation. As populations age, there will be a noticeable increase in public spending on healthcare and pensions.
Reducing public spending could lead to a reevaluation of the state’s role. According to David Miles, an official at the Office for Budget Responsibility, there is a significant expansion in expectations since the end of World War II. However, these expectations might not have aligned with the reality of recent poor economic growth.
There is a potential concern that investors may hesitate to purchase government bonds, leading to a significant increase in yields. In late 2022, the announcement of significant tax cuts and borrowing by then-U.K. Prime Minister Liz Truss caused bond yields to surge, only to be swiftly reversed. In Italy, the government’s ambitious spending plans led to a surge in borrowing costs in 2018. However, they eventually decided to back down.
In spite of Italy’s significant deficits, Prime Minister Giorgia Meloni of the populist Brothers of Italy has managed to prevent a rebellion from investors by scaling back her spending proposals and adopting a more cooperative approach towards Brussels. Italy, along with France, has been deemed to be in violation of deficit guidelines by the European Union.
However, Meloni’s example may not accurately reflect the potential outcomes if populists were to assume power in other nations. According to a study conducted in 2023, it was discovered that 51 populist presidents and prime ministers, spanning from 1900 to 2020, often face economic challenges. According to a study conducted by Manuel Funke, Moritz Schularick, and Christoph Trebesch of the Kiel Institute for the World Economy, there is evidence to suggest that populist governments have had a negative impact on GDP per capita and consumption over a 15-year period. The study also found that debt burdens and inflation tended to increase under populist governments compared to nonpopulist ones.
