Economists warn fiscal squeeze to hit euro zone next year

Return of tight budget rules will end three years of supportive fiscal policy

Lower public spending is set to curb euro zone economic growth next year as the bloc moves into an era of budget restraint, putting pressure on rate-setters to loosen monetary policy, according to economists.

EU finance ministers this week agreed to new fiscal rules that replace strict but hard to enforce budget constraints that have been suspended since the pandemic hit in 2020.

The measures will phase in tighter spending curbs, forcing high-debt countries to lay out plans to decrease debt, deficit and set a ceiling on annual expenditure, agreed with Brussels.

The new rules “will still be restrictive and for countries with high debt like Italy that is bad news,” said Lucrezia Reichlin, a professor at London Business School and former director general of research at the European Central Bank.


Meanwhile, the German government only agreed a budget for next year by cutting spending, scrapping some tax breaks and selling assets after the country’s constitutional court left a €60 billion hole in its spending plans.

Economists expect a jarring end to almost three years of supportive fiscal policy in the bloc, as the return to more restricted government spending further squeezes weak demand and activity. The euro zone economy contracted 0.1 per cent in the third quarter after stagnating for most of this year.

Jack Allen-Reynolds, an economist at consultants Capital Economics, said the new EU rules would be “more strict” by requiring high-debt countries like Italy to cut their budget deficits faster, but also “more lenient” in allowing countries to reduce debt levels more slowly.

Some fear the shift could even mark a return to the pre-pandemic situation in which the ECB had to shoulder most of the burden for economic stimulus, forcing it to resort to negative interest rates and large bond purchases to ward off deflation.

The ECB this month brought forward the timing of when it expected countries to repeal support measures that were ushered in to counter the recent jump in energy and food prices, forecasting a sharp tightening of the single currency bloc’s fiscal stance in 2024.

The central bank forecast the overall budget deficit of euro zone countries would shrink from 3.1 per cent this year to 2.8 per cent next year. That contrasts with a much more expansionary stance in the US, which the IMF expects to have a budget deficit of 8.2 per cent this year and 7.4 per cent next year.

Konstantin Veit, a portfolio manager at investor Pimco, said the ECB may struggle to boost economic activity: “We might end up in a situation again where governments are not investing enough and the ECB has to do more but monetary policy ends up pushing on a string.”

Economists have cut their 2024 growth forecasts for the euro area from 1.2 per cent at the start of this year to just below 0.5 per cent, according to Consensus Economics. The ECB last week cut its 2024 growth forecast to 0.8 per cent, down from 1 per cent previously.

The average forecast for German growth next year has fallen from almost 1.4 per cent at the start of the year to below 0.4 per cent. Many economists cut their forecasts after last month’s court ruling, which Tomasz Wieladek at T Rowe Price said would create a “fiscal drag” of €20 billion to €30 billion next year for the EU’s largest economy.

Martin Wolburg, an economist at Generali Investments, recently cut his forecast for German growth next year to only 0.1 per cent, warning the country’s “budget crisis will have a negative economic effect primarily via a hit to confidence”. He added that by damping down euro area growth, “it will at the margin increase the willingness of the ECB to embark on rate cuts”.

Minister for Public Expenditure and president of the Eurogroup of finance minister Paschal Donohoe told reporters this month that the EU’s new rules were “undoubtedly going to have an impact on the fiscal stance of the euro area”, which he described as “restrictive” in 2024. – Copyright The Financial Times Limited 2023