Public debt, the welfare state and the role of Europe

The title of my panel “Public debt: the end of the welfare state?” is a provocative question that seems particularly acute for France with its challenging levels of public debt, growing spending needs, a relatively generous social model and large public sector. Coming from the Jacques Delors Centre in Berlin, I do not want to enter French domestic debates but take a distinct European perspective and ask: what is the role of the EU in addressing the challenge of rising public debt?   What is the economic reform agenda that national politicians in their role as European leaders should pursue?  

Looking back to 2001

I feel particularly motivated to take this broad European perspective by the fact we are celebrating the 25^thedition of the Rencontres économiques d’Aix and that the declaration of the first Rencontres in 2001 provides already a strong focus on the European Union: “Depending on the measures that the European governments will take or not Europe may tilt towards a new era of growth or a new period of crisis.”

The recommendations that follow sound quite familiar to today’s ears – although debt levels are not explicitly mentioned: 

• a commitment “to growth and in this context to research, development and innovation”;
• a combination of demand side measures “with ambitious and converging programs of structural reforms notably concerning a better integration of the banking systems and financial markets” [sic!], and 
• a call for “the formulation of a new European social pact […] which will both integrate an indispensable flexibility and a response to the legitimate need for economic security“.  

One looks at these words and is struck by the sense of urgency. From today’s perspective, the early 2000s feel like an easy time: this is before September 11, before the rejection of the EU’s Draft Constitution, before the global financial crisis, before the euro crisis, before Brexit; before the pandemic, and before the war in Ukraine. Trump was still just a real estate tycoon from New York. The global temperature anomaly was only around +0.49°C above pre-industrial levels. The EU’s collective GDP in 2001 was four times larger than that of China and India together. France and Germany had similar debt-to-GDP ratios, at approximately 59% and 60% respectively. 

Look at where we stand now.  Have we failed? Yes and no. The European Union weathered most of these storms and has adjusted under pressure. But the political and economic price was high, important opportunities were missed and partly as a result the challenges we face today are so much more severe than in 2001. 

I will argue in this intervention that the recent reports by Enrico Letta and Mario Draghi lay down an economic agenda that can play an important role for squaring high public debt levels and huge financing needs. While national reforms remain central, we know – as underpinned again by the IMF‘srecent research – that they are much more effective if undertaken in tandem with European measures.  

Where do we stand today? 

Debt levels in the EU have gone up since the pandemic but are much lower than in the US; and on aggregate they do not challenge debt sustainability.  As of 2024, the average government debt-to-GDP ratio in the European Union stands at approximately 83%, up from around 79% in 2019, while in the United States it has risen to over 120% of GDP. Despite the increase and unfavourable structural outlook in terms of economic growth, demographic trends and political uncertainty, EU debt remains within manageable levels due to low interest rates and moderate borrowing costs, with the average interest burden on public debt staying below 2% of GDP.

But there is relevant heterogeneity among member states within the EU and we know from the euro crisis, how speculations about debt sustainability in individual countries can create shock waves across the union. As of 2024, countries with debt-to-GDP ratios above 90% include Greece (161%), Italy (137%), and France (111%), highlighting elevated debt burdens in parts of the EU. In contrast, Germany (64%) and Finland (73%) fall in the mid-range group between 60% and 90%, while countries like Estonia (18%), Bulgaria (23%), and Denmark (30%) remain well below the 60% threshold. 

At the same time, there are significant investment needs in the EU. The Draghi report mentions an annual figure of 4-5% of GDP (approx. €750–800 bn for additional public and private investment in defence and the digital and green transformation. The recent NATO summit commitment – to reach 5% of GDP defence spending (3.5% core +1.5% broader security) – is likely to inflate the defence component of that total. Roughly 22 EU countries are currently below the aimed for 3.5% of GDP. And countries with high debt levels, like Spain, Italy and Belgium have for far been clearly missed already the previous NATO target of 2%; and France is only marginally above 2%. Moreover, countries like Greece, but also Poland and many other Eastern European nations, will need to invest the most in the green and digital transformation. 

How can the necessary increase in public expenditure be financed? There are essentially four sources: 

1. Cuts in other expenditures (prioritising investments over consumptive spending, reforming the welfare state, and increasing efficiency of spending come with political and social costs); 
2. New debt (the fiscal space will depend on existing debt levels and refinancing cost and theburden is, of course, shifted to future generations); 
3. Raising taxes (a higher tax burden comes with political costs and has a dampening effect on growth); 
4. Higher revenues due to more growth and employment (investment shall finance itself in the medium to long run; yet, defence has a low fiscal multiplier; and the actual growth effect will also depend on the combination with structural reforms). 

While the precise combination of these four sources will be a national choice, the EU can and should play an important role for all of them. Let’s first look at fiscal policy directly (number 1 and 2) and then economic and financial policies more broadly (especially number 4).     

EU fiscal rules and the EU-budget  

There is clearly a shared interest in preventing negative spillovers from unsustainable debt in a member state for the Union as a whole. The EU fiscal rules are meant to ensure this. They have been reformed in 2024 with a stronger emphasis on incentivising structural reforms, prioritising investments and considering country-specific factors for assessing debt sustainability. Six EU countries (Finland, France, Italy, Romania, Spain and Belgium) have benefited from an extension of their fiscal adjustment path from four to seven years. Eight countries (Belgium, France, Italy, Hungary, Malta, Poland, Romania and Slovakia) are currently in an excessive deficit procedure. 

Enforcement of the new rules is a big question. In view of the need to reinforce Europe’s own defence capabilities, the application of the rules have now been softened: for defence spending, deviations from the recommended maximum growth of net expenditure of up to 1.5% of GDP is allowed over the period 2025 to 2028. The national escape clause has been applied to 16 member states upon their request (Belgium, Bulgaria, Czechia, Denmark, Germany, Estonia, Greece, Croatia, Latvia, Lithuania, Hungary, Poland, Portugal, Slovenia, Slovakia, and Finland), but countries, such as France, Italy and Spain, have not requested it. While Germany has not yet submitted its medium-term budget plans due to the change in government, the envisaged significant increase in debt-financed investment expenditure seems to stand in conflict with the reformed rules. Yet, the Commission has already signalled that it will probably not raise objections. 

So, what is the effect of the reformed rules? They still play a role as an anchor point for national debates. But for countries, like France and Italy, financial markets are currently more relevant and constraining than the rules. This comes with the known drawbacks and risks. For these countries, a sound and credible EU fiscal framework is important shield against the volatile and erratic nature of financial markets. If the current rules do not live up to this standard should not shy away from engaging in another reform.  

The fiscal coordination among member states has an additional dimension: steering the fiscal stance so that the expansion of fiscal policies in member states with fiscal space has positive spillovers to others. Here, Germany is a point in case. The Commission estimates that the planned increase in public investments in Germany would have positive economic spillovers to other EU Member States: EU GDP would be lifted by ¾% in 2035, with around one-third of this impact due to spillovers. Similarly, an increase in defense capabilities in Germany will increase the level of security for Europe with positive spillovers to member states less able or willing to spend.  At the same time, there is the risk that the large-scale issuance of debt in Germany, may raise interest rate pressures for other member states in the euro area. 

Good coordination of national fiscal policies is, therefore, a necessary but by no means sufficient condition for solid fiscal policies in Europe. Given the upcoming challenges, there is no way around complementing this with a strong joint spending leg at the EU level. Both Letta and Draghi make the case of a larger budget in their reports.   

For European public goods, there are savings from the scale and synergies of providing them together. Take the example of defence: even if the precise figures might be contested, Bruegel’s proposal for an European Defence Mechanism and similar IMF research highlights that common procurement under an EDM – with pooled demand, a single defence market, and cross-border competition – could halve unit costs on strategic systems and equipment. Common spending also addresses the problem of freeriding by those member states that structurally underspend. 

Moreover, a bigger EU budget that address common challenges for member states can make EU fiscal rules more credible and may increase compliance through two channels: by reducing the pressure on national budgets (especially in times of acute crisis) and by making access to common spending conditional on compliance with the fiscal rules. Furthermore, common issuance by the Union reduces borrowing costs for member states that face higher interest rates than what the Union has to pay as an issuer.  And a positive side effect of such common issuance is the widening of the availability of a euro safe asset which in turn would deepen capital markets in Europe and enhance the international role of the euro. 

At the same time, the EU has a strong tradition of being a regulatory giant and budgetary dwarf. Despite the temporary expansion of EU spending through common issuance under the Next Generation EU programme (during the pandemic), the EU budget remains small and clearly below 2% of GNI. There is limited progress on providing the Union with more own resources or taxing powers. Negotiations for the new Multiannual Financial Framework (2028-2034) will be very challenging and make “doubling of the investment capacity” of the EU (as Emanuel Macron argued for in his second Sorbonne speech in 2024) and further large-scale issuance currently rather unlikely, notwithstanding strong economic arguments backing it. 

Boosting growth and private financing through the single market 

If a much larger EU-budget is not happening in the short- to medium, the other recommendations outlined in the reports by Enrico Letta and Mario Draghi become even more important: the deepening of the single market for goods and service to boost growth for the real economy; and the deepening the single market for capital to match better the high saving rates with the large investment needs.    

According to IMF estimates, the average cost of trading goods across EU member states is equivalent to a tariff of around 45% and of around 110% for services. Dismantling these internal barriers would unlock vast economic potential. This is particularly evident for energy markets in an environment where high energy costs are a key competitiveness challenge for the industry in Europe.   

Moreover, a Savings and Investments Union would mobile private capital by harmonising rules, reducing legal and tax barriers, and creating deeper, more liquid markets. It builds on the premise that by integrating capital markets their relevance for financing the economy will grow significantly. A single rule book and central supervision are key instruments to achieve this. 

Yet, a stronger role for capital markets cannot be steered through EU harmonisation alone. It needs to be complemented by national measures or by EU measures that remain compatible with national traditions. In this respect, the 28th regimes is a good example of a potential measure that could be voluntary for the firms and be introduced first by those member states that want to go ahead. Moreover, the structure of national pension systems significantly shapes household saving patterns.  Shifting toward more funded or mixed systems could unlock long-term capital for market-based financing, as examples of Denmark, the Netherlands and Sweden, show. While these are national choices closely linked to the respective welfare models, EU coordination and incentives could help informing national reform debates and enhance the positive impact on capital markets integration and long-term growth in Europe. 

Finally, a strategic blending of private and public money can enhance the effect of public expenditures: the EU could further enhance frameworks that link public guarantees, co-investments, and tax incentives to investments in strategic areas and address the financing gap that start-ups hit in Europe when they enter the scale-up phase. Public institutions such as the European Investment Bank (EIB) with its European Investment Fund (EIF) and national promotional banks play a critical role in this respect. 

The courage to dare change 

The core thesis of the historian Alan S. Milward in his 1992 book “The European Rescue of the Nation-State”is that European integration was not a step toward the erosion of national sovereignty, but rather a strategic choice by national governments to strengthen and modernize their nation-states in the postwar context. Crises have been an important catalyst helping national politicians to take these steps.

We are now in a situation where further European integration is needed to help addressing the challenges that nation states face. Where elevated national debt, low growth and large financing needs should put pressure on national politicians to take difficult choices and opt for more Europe.  

There is the risk that national politicians do not dare to take these choices – interpreting the raise of extreme right populism as a sign that they should not integrate Europe further and pursue instead national strategies. Yet, opinion polls show that citizens are willing to accept European solutions if these are effective. 

In this respect the last part of the declaration from Rencontres d’Aix in 2001 is particularly interesting, as it expresses a farsighted warning:  “those measures will prove meaningful and positive: only if the institutional and administrative machinery at the level of the countries and Brussels move out of their current paralysis. [….] And only if the ‘physical’ introduction of the euro is a success.”  The failure of the Draft Constitutional Treaty in 2005 and the euro crisis from 2011 show that getting it right is a daunting task. But today we may not have a second chance. As this year’s motto of the Rencontres rightly states: “Facing reality: a call to action”.