The steady rise in massive deficits and debt-to-GDP ratios has made public debt a staple of the financial press.
However, in the wake of European elections and the opening of excessive deficit procedures, this topic - neglected by previous governments - is once again becoming a political issue. By 2025, there will be no getting around the issue of fiscal rebalancing in developed countries.
An unprecedented situation
Since the creation of the eurozone, three major crises have alone accounted for 35% of the rise in European public debt, which stood at €13,800 billion at the end of 2023.
Whereas the average deficit has fluctuated between -0.5% and -2%, excluding times of crisis (the financial crisis, the pandemic and hyperinflation), it exploded to an average of 3.5% of GDP in 2023. Eleven countries - including Belgium and France - have significantly breached the 3% mark. In 2024, these two countries’ deficits could reach 4.9% and 6% respectively, a level not seen since the post-war period, excluding times of crises.
How can these deficits be explained? And how can public debt, which needs to be controlled in the absence of a structural crisis, be contained.
2025
According to the debt sustainability equation, it is hard to see how the three structural factors that reduce public debt could help address this situation.
- Inflation. In 2023, 8% hyperinflation temporarily brought debt under control. By 2025, inflation is expected to be close to 2.0%, which will not be enough to erode the public debt ratio.
- The cost of debt. The sharp fall in interest rates between 2010 and 2020 enabled governments to extend the duration of their debt, from 6.7 years to 7.9 years at an average rate of 2.65%. In 2025, despite the anticipated reduction in key interest rates, the cost of debt will average 2.25%, which will not be enough to curb debt.
- Deficit. Governments will still have the option of reducing their spending or increasing their revenues. Average spending has risen across Europe, notably due to the effect of an ageing population, which is weighing on deficits. Revenues, meanwhile, will depend mainly on the growth outlook, which will be weak at close to 1%. Given these conditions, the debate on taxation is likely to be central. With an average corporate tax rate of 21.3%, the EU could tighten the screws on businesses or households, which would have an impact on consumption. Nevertheless, it will be complicated to reduce such deficits without further impacting growth prospects, which could ultimately prove counter-productive - let us not forget the negative effect of austerity programmes and severe reforms on debt ratios in Greece.
Wildcards
Over the last 20 years, however, the European Union has been able to get around this inextricable equation by using two wildcards that have reassured the financial markets.
- Central bank intervention. The ECB has pulled out the monetary bazooka several times. Since the launch of the quantitative easing programme in 2015, it has purchased no less than €4,200 billion, or 60% of government public debt, keeping the cost of debt under control.
- Debt pooling. This was to be a European ”game changer”. In response to the Covid crisis, the eurozone launched a joint debt programme via the NextGenerationEU plan, which is set to exceed €700 billion by 2026. Can such a programme be renewed in the short term? It seems unlikely.
These two wildcards have significantly strengthened Europe’s creditworthiness and its credibility in the face of systemic risk. However, with no major crisis on the horizon, it now seems unlikely that fiscal authorities, under pressure from populist movements and monetary authorities, will make use of them.
Risk premiums
Debt crises do not just happen. In 2010, the average European deficit of 6.3% created an unprecedented crisis. What will happen if France’s deficit exceeds 6%?
Risk premiums of core eurozone countries are slowly but surely widening.
Over the past five years, France’s spread has averaged 42 bps. It is now at the same level as Spain’s, at 78 bps, approaching the debt levels of Greece, once the sick man of Europe. If structural reforms are not implemented by new governments, this spread could continue to spiral out of control, creating tricky financial conditions for the private sector.
While Europe is not alone in facing this major challenge (United States, Japan, etc.), the issue of public debt is becoming central to political and economic debates. Bond investors will need to be extremely vigilant in 2025.