Government spending cuts in the EU are set to hit investment and growth at a time when the region is already struggling to keep up with the US, economists have warned.
After years of fiscal excess during the Covid-19 pandemic and the energy crisis sparked by Russia’s invasion of Ukraine, Brussels has reinstated rules requiring member states to rein in budget deficits to a maximum of 3 per cent of GDP. The end goal is to lower government debt to 60 per cent of GDP.
But the restraint comes at a time when Europe’s economic powerhouse, Germany, is facing existential threats to its export-led business model and more investment is desperately needed across the bloc.
Donald Trump’s definitive win — and his threat of 10-20 per cent tariffs on Europe’s manufacturers — has exacerbated concerns over longer-term growth prospects.
“I don’t think we will get the investment we need and that’s bad,” said Jeromin Zettelmeyer, director of think-tank Bruegel. “We can’t have effective implementation of the [EU’s] fiscal framework, a substantial increase in public investment and no new EU level funding at the same time.”
Filippo Taddei, senior European economist at Goldman Sachs, said the consolidation was not going to help in correcting “the very sizeable investment gap between the US and the European economy”.
The investment bank believes consolidation will cut around 0.35 percentage points off Eurozone growth per year in 2025, 2026 and 2027.
The IMF, which recently downgraded its growth projections for the Eurozone to 1.2 per cent next year, also expects the fiscal rules to add to strains on the economy, shaving 0.1 percentage points off annual GDP.
The US economy, meanwhile, is set to expand by 2.2 per cent over the same period. Policymakers there are also expected to maintain a more expansionary fiscal policy.
The Congressional Budget Office, the independent fiscal watchdog, predicted deficits of 6.5 per cent in 2025 and 6 per cent in 2026 ahead of Trump’s win.
Many economists believe the president-elect’s pledge to make his 2017 tax cuts permanent will raise the deficit by several percentage points and temporarily lift demand.
Trump claims that he will shrink the deficit by aggressively limit government spending, appointing Tesla founder Elon Musk and fellow entrepreneur Vivek Ramaswamy to find ways to make swingeing cuts.
The EU is estimated to need €800bn-worth of public and private investments a year to address threats to its longer-term economic competitiveness, according to a report by former ECB president Mario Draghi published earlier this year.
While private investment is expected to contribute the majority, substantial public investment is still seen as vital.
“There’s a tightening bias for fiscal policy over [several years],” said Adam Posen, director of the Peterson Institute think-tank in Washington. “You’re very unlikely to be increasing public investments in that environment.”
Europe’s economy is facing several longer-term challenges — from ageing societies shrinking its labour force to combating climate change and boosting its defence capacity.
Trump’s return to office next year has already led to a rethink on security spending, with Brussels potentially redirecting tens of billions of euros of its common budget.
Economists believe a more radical rethink on stimulus is needed.
Posen said the lack of even an “aspirational” debate on more investment was “incredibly shortsighted” when the need was so great — and likely to become more so.
Economists acknowledge that governments around the world need to address their ballooning deficits.
Since the pandemic first struck, sovereign debt stockpiles have soared. The IMF said last month that public debt globally had now hit $100tn, and was set to rise further in the years ahead.
While Eurozone member states have already cut back on spending more than the UK, US and China, the region’s debt-to-GDP ratio is up from 83.6 per cent in 2019 to 88.7 per cent at the beginning of 2024. Deficits in some of the largest economies — including France — have also expanded.
After suspending EU fiscal rules at the onset of the pandemic, Brussels reinstated them this year. The result has been a tightening in fiscal conditions that is set to continue in the years ahead.
So far, 21 member states have submitted plans on how they intend to rein in spending over the next four to seven years.
Among the most closely watched is a proposal from new French prime minister Michel Barnier that would shrink the deficit in the EU’s second-largest economy to within the 3 per cent ceiling by 2029.
Spain and Italy both plan to meet the threshold earlier, in 2024 and 2026 respectively. While Spain’s target seems attainable, thanks to one of the strongest growth rates in Europe, economists view Italy’s plans as ambitious.
Both France and Spain have helped bolster regional growth in 2024 at a time when the German economy has stagnated.
Political chaos in Berlin has meant it is yet to present its spending plans to Brussels. The region’s largest economy has more fiscal space than other EU member states, with its deficit set to reach just 1.6 per cent of GDP this year — well within the 3 per cent limit.
With interest rates still relatively high, Zettelmeyer noted that monetary policy could provide a temporary boost. “The ECB has enough firepower to offset the fiscal drag,” he said.
While rate cuts would boost growth, such a solution is “not ideal,” said Posen.
Lower rates and expenditure cuts combined would widen inequality — tighter fiscal policy usually affects poor people more, while looser monetary policy benefits asset holders first — and leave the ECB in a tough spot, should inflation return, Posen said.
Data visualisation by Janina Conboye