Although euro area fiscal deficits and government debt increased sharply during COVID-19 and both deficits and debt remain above pre-pandemic levels, government debt will remain manageable over the next few years, even if euro area interest rates remain somewhat higher than before the pandemic; over the medium-term, however, most euro area countries will need to implement expenditure reform to ensure sustainability, which will prove contentious at the domestic and the intra-euro-area level. At nearly 90% of GDP, euro area government debt is high, but compares relatively favorably to the United States (120% of GDP) and Japan (255% of GDP). The sharp, COVID-19-induced economic downturn, which translated into higher spending and lower revenues, sharply increased fiscal deficits and debt ratios. However, the inflation spike of 2022-23 helped reduce euro area debt from a peak of 97% of GDP in 2020 to 90%, despite disappointing economic growth performance recently. This compares to a pre-pandemic debt level of 84% of GDP. The average euro area debt level disguises significant intra-euro differences, which is reflected in different levels of sovereign credit and default risk. The debt ratio is highest in Greece (170% of GDP) and lowest in Luxembourg (28% of GDP). However, Greece’s debt ratio is lower today than before the pandemic when it stood at 186% of GDP. By contrast: at 110% of GDP, France’s debt ratio is 12 percentage points higher today than before the pandemic; at 143% of GDP, Italy’s ratio is 9 percentage points higher; and at 66% of GDP, Germany’s is 6 percentage points higher than in 2019.
The prospect of higher interest rates in the context of continued subdued economic growth and increasing non-interest spending pressures will require further fiscal adjustment down the line in order to ensure long-term debt sustainability. The near-term outlook will be manageable, however, thanks to an underlying fiscal stance that is broadly consistent with a stable or only slowly increasing debt ratios in the financially weaker countries. Economically speaking, long-term debt dynamics are a function of real economic growth, real interest rates and the underlying (structural or cyclically adjusted) fiscal stance. Assuming a long-term real interest rate of 1% and a real GDP growth rate of 1%, euro are governments need to generate a primary (before interest) fiscal balance of at least zero to stabilize the debt ratio. The primary deficit in 2023 was 1.7% of GDP, but the IMF projects the deficit to fall to zero by 2028, which, based on the above assumptions, would translate into a stable debt-to-GDP ratio after 2028. However, all euro area countries are faced with increasing pension and healthcare, climate transition and defense spending. Stabilizing the debt ratio over the long term will require higher taxes or a stabilization of non-interest expenditure as a share of GDP. This, in turn, will require politically painful domestic economic and financial reform. It will also lead to increased disagreement and tensions within the euro area over risk sharing. Countries with worse underlying fundamentals will need to pass more extensive economic reforms (France, Italy) than countries whose debt will be declining in the next few year (Germany).
In the interim, the substantial institutional reforms of the past decade and a half will limit the risk of major financial distress by providing the euro area with adequate tools to prevent a liquidity crisis from spiraling into a solvency crisis and thus buy distressed countries time to adjust their policies. Originally designed without a financial backstop, in part due to a no-bailout commitment, the euro area has undergone a dramatic institutional evolution over the past decade and a half. The reforms have created a potentially infinite liquidity backstop provided by the European Central Bank (ECB). They established a bailout fund in the guise of European Stability Mechanism (ESM), which allows distressed euro member to tap emergency funds to prevent a liquidity-driven default in the context of policy adjustment and conditionality. The reforms also updated the original Stability and Growth Pact (twice), renamed Fiscal Compact, which provides for greater transparency and surveillance and its sets more specific commitments to bring national fiscal policy in line with mandated targets. The euro area also took steps towards a banking union to prevent banking sector instability from causing sovereign distress. Taken together, this new institutional framework limits the risk of sovereign and systemic banking sector distress. However, the euro are does remain an “imperfect” monetary union due to limited resource transfers and insufficient joint resources to backstop the euro area banking sector, even though neither of these is strictly necessary to ensure the long-term viability of the common currency.
Continued disagreements over issuing joint debt and creating a euro area deposit insurance scheme will continue to prevent significant institutional progress. There exists a sharp divide between “creditors”, countries with strong public finances, and “debtors”, countries at significantly greater risk of experiencing financial distress, largely on account of their higher debt levels. Debtors want more risk sharing, and creditors are reluctant to share risk with financially weaker countries, as they fear one-sided risk sharing and concomitant one-way resource transfer. Creditor countries prefer that risky countries assume the risks and costs of their own actions, and are only prepared to share risks if it helps increase systemic stability at limited potential costs. Debtor countries prefer to share risks with financially countries. Negotiations over further reform aimed at increasing systemic stability and resilience will require agreement on how to allocate the potential costs of further risk sharing. Short of a crisis that requires further reform to preserve monetary union, only limited and gradual institutional progress will be made in the next few years. But the current framework goes a long way in terms of limiting the risk of sovereign distress as well as mitigating the effects of sovereign distress.
The battle lines are drawn between “creditor” and “debtor” countries. By 2028, Cyprus, Germany, Ireland, the Baltic countries, Luxembourg, Malta and the Netherlands will have debt ratio below 60% of GDP. By contrast, Belgium, France, Greece and Spain will continue to have debt ratio of more than 100% of GDP. In Austria and the Netherlands, debt ratios will remain stable. This helps draw the “battle lines” in terms economic policy and institutional reform. The need for reform will be greater in Belgium, France and Spain, given less favorable debt dynamics. So will be the demand to share risk in the euro area. Calls from more highly indebted countries like France and Italy for greater joint issuance of debt will not be heeded by countries with lower debt and sounder financial and fiscal position, unless there is another major emergency (like COVID-19) or there is a risk of severe euro area destabilization. This is also why only very limited progress will be made in terms of further strengthening the euro area institutionally.