Although the EU is still on the brink of a recession, the bloc's budget rules are coming back to the fore. The rules that have been suspended since the start of the pandemic are expected to be back in place by 2024, albeit in an updated form. The current EU budget rules are laid down in a complex set of rules based on the Maastricht Treaty, the basic idea of which can be summarised as follows: Member States should keep government debt below 60% of GDP and their annual budget deficit below 3% of GDP. However, these rules have never been strictly enforced by the EU, and even fiscally conservative countries like Germany have at times run deficits above 3%.
Germany has fiscal space, but will only use it sparingly
The German economy is in a depressed state, with the country's industrial export growth engine struggling in particular. Despite this, the government plans to tighten the budget. German fiscal consolidation has already begun this year as pandemic and energy crisis-related spending has been phased out (Figure 2). This partially explains Germany’s underperformance this year relative to other major eurozone economies.
Compared to other European countries, Germany still has considerable fiscal space, with a debt-to-GDP ratio of 67% in 2022. With serious fears about whether Germany can remain competitive in key emerging sectors, calls for more fiscal stimulus will grow louder. The government has already committed multi-billion euro subsidies to incentivise big investments in semi-conductors and batteries.
However, a broader fiscal stimulus to boost growth is unlikely. The so-called "black zero," the promise of a balanced budget that was even included in the German constitution, limits the government's options. One way for the German government to avoid the debt break is a shadow budget through special funds, which has recently been used for a EUR100bn defense fund. The German government expects a deficit of 2.5% of GDP in 2023 and 2% in 2024. We expect the deficit will remain larger than this (Figure 1), as we expect weaker growth. But we do expect the German deficit ratio to fall below 3% of GDP in 2024 and remain there for the rest of our forecast horizon. Compared with pre-pandemic levels, however, when Germany ran a budget surplus, fiscal policy will still be looser. We expect government spending to weigh on growth in 2023 and to contribute directly to growth only marginally from that point onwards.
Italy, Spain and France are also expected to tighten their belts
Italy, the country with the highest debt-to-GDP ratio among the big four European economies, has recently started to withdraw fiscal stimulus. The Superbonus scheme, which subsidised renovations through tax credits, will most likely be scaled back. The Italian debt to GDP ratio already fell significantly in 2022, also thanks to high inflation. Recently, however, the government raised the expected budget deficit for this year to 5.3% of GDP as the cost of the Superbonus skyrockets to around EUR100bn. Deficit expectations for 2024 were raised to 4.3%. This resulted in a sharp increase in spreads on Italian government debt. Only in 2026 does the Meloni government expect the public deficit to be reduced to 3% of GDP. Even these figures seem optimistic; we do not expect the Italian debt ratio to fall below 3% before 2027. The official Italian deficit expectation for 2024 is based on the assumption of 1.2% growth in 2024 and 0.8% this year. By comparison, we forecast the Italian economy to grow by only 0.5% this year and by 0.4% in 2024. The planned fiscal consolidation means that government spending will be a drag on growth throughout our forecast horizon (see Figure 2).
Spain’s fiscal consolidation plan, proposed by the acting prime minister and his government, targets a decrease of the deficit to 3% in 2024 and 2.7% in 2025. The forecast is based on an optimistic growth outlook of 2.4% in 2024 compared to our forecast of 0.8% growth. We expect the Spanish deficit to GDP ratio to stay above 3% throughout our forecasting horizon, but we do expect the gap to 3% to close gradually as government spending will stay more restrictive (see Figure 1).
In France, the plans for budget consolidation are more moderate. The country aims to reduce the deficit from the 4.9% of GDP targeted this year to 4.4% in 2024. Again, however, the official figures are based on a much more optimistic GDP forecast than the consensus and our forecast (1.4% versus 0.5% for 2024). An overshoot of the deficit target is therefore likely. The government has announced some tax increases to boost the budget such as the end of the Pinel system that subsidised owners of new homes through tax reductions and was introduced to stimulate construction. On the other hand, the government will uprate tax brackets for inflation, which will deprive it of substantial revenues. We expect government spending to contribute mildly to growth in France throughout the forecast horizon, at the expense of a deficit that will remain relatively high.
Major challenges will make fiscal consolidation more difficult, and potentially dangerous
Looking at the budget plans of European governments and our forecast, the trend toward fiscal consolidation in the coming years seems evident. This has implications for growth. Figure 2 shows that government spending played an important role in stimulating growth through the pandemic and recovery, and this tailwind will expire if not reversed. However, tighter fiscal policy will give the ECB more space to loosen monetary policy. And given the threat that high debt levels pose to the single currency, as well as the long-term challenges to public finances from demographics and climate change, both the European Commission and national governments are likely to place a high priority on stabilising debt levels.
