Europe’s fiscal–geopolitical vicious circle

Growing public debt in Europe is no longer just the result of temporary crises, but a persistent, structural trend that dates back to the 1970s. The drivers are an ageing society, low economic growth and the political inability to limit spending. The crises of 2010–2015 exposed the weaknesses of the monetary union – macroeconomic imbalances, fiscal policy mistakes and the lack of common assistance mechanisms. The pandemic, in turn, has further increased government debt. According to the latest regional economic outlook by the International Monetary Fund (IMF), without growth-promoting reforms in Europe, there is a risk of a significant increase in government debt. By 2040, this could reach an average of 130 per cent of gross domestic product, which is 40 percentage points more than the IMF considers stable. In the event of external shocks, an even higher debt ratio is possible.

In addition to the legacy of structural problems, budgetary problems are increasingly exacerbated by geopolitical factors. On the one hand, there is an urgent need for higher spending on defence, energy transition, industrial subsidies and aid to Ukraine due to Russia’s aggression and economic competition from China. On the other hand, rising interest rates on government debt worldwide are limiting European Union (EU) countries’ ability to borrow. This creates the vicious circle: Limited fiscal leeway deepens geopolitical dependence, and geopolitical dependence forces further spending.

Hidden costs of public debt

In the context of rising debt, reference is typically made to the growing costs of debt servicing. This narrows the scope for fiscal policy and diverts resources from growth-promoting sectors such as research and education.

However, rising debt also has hidden geopolitical costs: It reduces the ability of EU countries to act together, exacerbates disagreements – for example between north and south or between large and small member states – and weakens confidence in central institutions such as the European Commission, which monitors compliance with fiscal rules, and the European Central Bank (ECB), whose monetary policy could increasingly be oriented towards stabilising member states’ debt.

In addition, high public debt makes EU countries more vulnerable to external factors such as changes in interest rates internationally. Public debt can also become an instrument of external influence on EU member states. The increasing involvement of investors from third countries – including China and the Gulf states – in European bond markets raises the risk that financial dependencies will be exploited politically.

Escaping the vicious circle

Unlike the United States and China, the EU has few options for mobilising capital. Limited fiscal space and weak capital markets make it vulnerable to external shocks. The integration of financial markets and the restoration of competitiveness in Europe are progressing slowly, according to the conclusions given in reports by Enrico Letta and Mario Draghi. A rapid breakthrough that would lead to a noticeable inflow of capital to Europe cannot be foreseen.

The EU’s highly decentralised fiscal system relies heavily on the economic future of its three largest member states – Germany, France and Italy. Together, these countries account for about two-thirds of the eurozone’s public debt. However, given their limited fiscal leeway, they can no longer reconfigure their economic models and respond to geopolitical challenges. France’s deteriorating public finances are leading to growing populism in economic policy debates. This not only undermines confidence in the country’s economic policy-making capabilities, but could also put the already fragile structure of the EU’s monetary union to the test.

Amid global economic competition, the stability of the euro and the internal market are among the EU’s few “hard” assets that could easily be lost. A new euro crisis – in which Germany no longer plays a stabilising role and the ECB’s measures may no longer prove effective – would not only be an economic but also a geopolitical disaster for the EU. Sustainable public finances must therefore become an essential part of its geopolitical resilience.

 

Dr Paweł Tokarski is a researcher in the EU/Europe research group.