In the wake of the Covid-19 pandemic and Russia’s invasion of Ukraine, both the United States and Europe embarked on significant borrowing endeavors. However, as these global emergencies gradually recede into the past, a noteworthy divergence has emerged: While the United States continues to grapple with soaring deficits, Europe is on a trajectory to significantly narrow its own fiscal gaps.
This situation stands in stark contrast to a decade ago when post-global financial crisis deficits pushed several Eurozone members to the brink of default. The lessons drawn from that tumultuous episode, coupled with the Eurozone’s budgetary regulations, have instilled a sense of fiscal discipline in European governments—a discipline conspicuously absent in the United States.
However, despite Europe’s commendable efforts, it seems that this fiscal prudence has gone somewhat unnoticed. Over the past month, government bond yields have surged globally. While numerous factors contribute to this phenomenon, such as central banks’ efforts to rein in inflation, one critical factor is the persistently high U.S. deficit.
As of the latest figures, the U.S. government reported a deficit of $1.7 trillion, equivalent to 6.3% of its Gross Domestic Product (GDP), for the fiscal year ending September 30th. This marked an increase from the previous year’s $1.4 trillion, which was 5.4% of GDP. Moreover, without accounting for an adjustment related to the administration’s abandoned student loan cancellation program, the deficit would have surged to nearly $2 trillion—an alarming doubling from the previous year.
The International Monetary Fund (IMF) released projections earlier this month, forecasting that U.S. deficits for all levels of government will reach 7.4% of GDP in 2024 and 2025. In contrast, Europe paints a different picture. The IMF anticipates that the combined deficits of Eurozone governments will decrease to 3.4% of GDP this year, down from 3.6% in 2022, and further decline to 2.7% in 2024.
Remarkably, even those European nations that found themselves in the throes of crisis a decade ago are poised to witness much smaller budget deficits. Greece, for instance, is expected to see its deficit drop from 2.3% of GDP in the previous year to 1.6%. Portugal’s deficit is projected to decrease from 0.4% of GDP to a mere 0.2%. In Ireland, a budget surplus is on the horizon for the second consecutive year. On the other hand, countries like Italy and France continue to grapple with deficits hovering around 5% of GDP.
Christian Keller, Chief Economist at Barclays, observes this divergent path and comments, “It’s really quite striking how the paths have diverged. There doesn’t seem to be any effort in the U.S. to bring spending down or raise revenues.”
If these projections hold true, European governments will no longer be the primary contributors to the global debt burden. The IMF estimates that government debts are poised to increase by 1 percentage point of economic output in the coming years, but this is primarily attributable to the United States and China. Without these two major players, the debt load would be on a downward trajectory.
A little over a decade ago, Europe was at the epicenter of global concerns regarding escalating government debts. Greece, Portugal, Ireland, and Cyprus faced bailouts, with Greece even defaulting on some of its debts. Thanks to a combination of bailouts and support from the European Central Bank, coupled with the onset of the pandemic, most European governments managed to narrow their deficits.
In contrast, the United States began to outpace its European counterparts in terms of deficits in 2016. The United States also engaged in heavier borrowing during the pandemic. Crucially, it appears to lack a clear path to reducing these deficits: The Biden administration has proposed tax increases that face resistance from both Republicans and some Democrats in Congress, while Republicans advocate for spending cuts that the administration does not support.
The framework of the European Union’s budgetary rules was established in 1993 as part of the Maastricht Treaty, which laid the groundwork for the Euro. These rules stipulate that budget deficits should not exceed 3% of GDP. In 2020, these rules were temporarily suspended to allow governments to respond to the pandemic. They were later extended to provide support to households in the wake of rising energy prices following Russia’s invasion of Ukraine. Consequently, deficits widened, and debts mounted.
The anticipated decline in European deficits largely reflects the phasing out of this emergency support. However, beyond this, the painful memories of Europe’s debt crisis serve as a strong deterrent against the prospect of rising deficits. Valdis Dombrovskis, the EU official responsible for enforcing budget rules, emphasizes the need to restore fiscal prudence, stating, “We need to bring the public finances back on track. Fiscal policy needs to stay prudent.”
European governments, however, are not advocating for a simple return to pre-pandemic rules. Some criticisms have arisen, particularly regarding the notion that these rules discouraged investment in growth-enhancing areas, including measures to promote a greener economy. Some governments are pushing for the revision of these rules to exempt certain types of investment spending, while others argue that such exemptions may render the rules too lenient. In the absence of a consensus on these changes, Europe may find itself reverting to the previous constraints by 2024.
The United Kingdom, although operating under different self-imposed rules, shares the goal of reducing its budget deficit to below 3% of GDP in the coming years. In late 2022, the UK faced a debt scare when then-Prime Minister Liz Truss unexpectedly announced significant tax cuts, triggering a government bond market selloff. Truss was swiftly replaced by Rishi Sunak, whose government has opted for tax increases to curb debt. This involves freezing income tax rate thresholds, which has the effect of pushing more taxpayers into higher brackets as their incomes rise in tandem with inflation.
The UK’s nonpartisan Institute for Fiscal Studies estimates that this freeze could generate an additional £52 billion (approximately $63.26 billion) in tax revenues by the fiscal year ending March 2028, equivalent to a 6 percentage point increase in income tax rates.
However, not all European governments are inclined to adopt such stringent measures. Both Italy and France have recently unveiled budgets that project a slower decline in deficits towards the sub-3% target than initially anticipated. In response, the European Commission may declare the Italian government in violation of the rules, potentially depriving it of access to a European Central Bank program designed to mitigate sharp increases in borrowing costs.
In conclusion, the fiscal trajectories of the United States and Europe have diverged significantly in the aftermath of recent global crises. Europe’s disciplined approach to narrowing deficits stands in sharp contrast to the United States’ continued expansion of its fiscal gap. While Europe’s efforts may be underappreciated, they reflect a commitment to maintaining fiscal prudence, guided by the painful lessons of its past debt crisis. As the global economic landscape evolves, these fiscal choices will continue to shape the economic future of both regions.
