Can Europe Fund Its Future Without Adding Debt?

Europe is entering a new fiscal era. For several decades, the region’s nations could afford to expand welfare programs because declines in defense spending and debt costs helped absorb the expense. Now that backdrop is changing as aging populations drive pension costs higher, interest rates increase the cost of servicing debt and geopolitical tensions require greater investment in defense.

Morgan Stanley Research expects governments across the region to face a difficult balancing act over the next decade: making tough budget choices that support growth without increasing debt.

“Borrowing cannot be the only answer,” says Jens Eisenschmidt, Chief Europe Economist at Morgan Stanley Research. “Markets will reward plans that boost growth, not debt.”

Fiscal Pressures Are Building

Public spending already accounts for nearly half of gross domestic product in many European countries. Social benefits and transfers—or government programs that finance and provide support and subsidies to individuals and families—account for nearly 50% of total spending. “In three of the four largest eurozone economies—France, Italy and Spain—public debt is already above 100% of GDP,” Eisenschmidt notes.

Without policy changes, he says, the combined effects of population aging, higher defense spending and rising debt-servicing costs could increase public spending by at least 3 percentage points of GDP across most euro-area countries by 2040.

Some countries face even greater pressure: Spain and Portugal could see spending rise by more than 5 percentage points of GDP. Meanwhile, Austria would experience the smallest increase, at roughly 1.5 percentage points.

Outside of the euro area, the UK faces a similar challenge. Pension and defense spending as a percentage of GDP is likely to increase by 1.4 points by 2040, while costs to service debt are already above pre-pandemic levels.

“The composition of spending pressures differs by country, but the direction is the same: The fiscal tailwind from falling rates and lower defense spending has turned into a headwind,” Eisenschmidt says.

Reallocating, Not Simply Cutting, Spending

For most countries in the region, the challenge is less about reducing overall spending than about reallocating resources within budgets that are already highly constrained. Pension payments, healthcare, defense, public safety and interest expenses are difficult to reduce and, in many cases, are expected to continue rising.

“Outright spending cuts are difficult to implement at scale,” Eisenschmidt says. “A more feasible route would be to slow the growth rate of some expenditures, allowing them to decline as a share of GDP over time.”

Morgan Stanley Research sees a combination of potential policy measures. These include:

• Gradually slowing the growth of selected government expenditures by limiting increases to the rate of inflation.
• Protecting public investment, including infrastructure projects that can improve long-term productivity.
• Strengthening Europe's defense-industrial base by directing more procurement toward domestic suppliers.
• Reforming pension savings systems to encourage greater household investment and deepen local capital markets.
• Encouraging private investment in sectors with higher long-term growth potential.

While tax increases could play a role in some countries, Morgan Stanley Research does not expect higher taxes to be a universal solution. Existing tax burdens and political constraints mean revenue measures are likely to vary across countries.

Economic growth is a key part of the solution. The more GDP grows, the easier it will be for governments to bring spending into balance without sacrificing jobs, investment or living standards.

In Morgan Stanley Research projections, if real GDP grows by 1% annually, a freeze on a spending envelope worth 25% of GDP could free up roughly 0.25 percentage points of GDP in government budgets each year—about 1.2 percentage points by 2030, or roughly half of the primary-balance adjustment required under European Union fiscal rules.

If real GDP growth reaches 2% annually, the cumulative fiscal space could approach 2.3 percentage points by 2030, potentially meeting the required adjustment without raising taxes or cutting spending.

"This is meaningful, but not a silver bullet," Eisenschmidt says. "It requires several years of discipline, and the arithmetic is highly sensitive to growth."