Fiscal policy will remain accommodative, but prudence is not out of the door

At the national level, governments had started 2022 moving away from very expansionary policies toward normalisation as the pandemic had moved into a less impactful phase for the economy. The new geopolitical reality is now adding to fiscal spending needs though, likely reversing the course for eurozone governments. We expect fiscal spending to change in three main ways, resulting in more spending for 2022, but more notably also resulting in higher structural spending beyond 2022.

Defence spending is set to see a significant revival. Germany led the way by announcing plans to use €100bn from the 2022 budget on the military and to reach 2% of GDP in annual defence spending in the years to come. The latter is something that many eurozone countries fall short of and, as most are NATO countries, they are therefore not fulfilling their commitment. The EU summit in Versailles agreed on substantially increasing defence expenditure and investment. Boosting military spending to 2% of GDP would result in the eurozone budget deficit surpassing 4% of GDP – it is currently at just 1.5% of GDP, when all other expenditures remain unchanged.

Energy dependency reduction is set to be a focal point of government policy in the short and medium-term. The Commission’s REPowerEU plan is at the heart of this and has drafted the main pillars for government action, which we have addressed in more detail here. Short-term plans include shifts away from energy dependence on Russia, which is hard to achieve without increasing spending. Looking at the medium-term, plans for the green transition are now going to be done sooner to help achieve energy independence goals. These plans include sizable investments in renewables, but also investing in gas and electricity infrastructure, among others.

Fiscal support for households is being ramped up to counter the negative purchasing power effects of higher energy prices. This already happened at the end of last year to a modest degree when natural gas prices first spiked, but the current situation is causing governments to add new rounds of stimulus. We wouldn’t discount eurozone governments deciding on support schemes for companies in the coming months as business costs are up significantly as well due to higher energy prices.

There are no easy choices on the table here. The structural increase in spending is going to come with either the running up of already high national debt levels (which would mean a further breach of the Stability and Growth Pact [SGP] and realistically demand more far-reaching reform), austerity with other parts of the government budget, or further steps towards a transfer union. Tough choices generally mean delayed decision-making in the EU, but crises can make the EU make groundbreaking decisions at decent speed as the Covid-19 crisis showed. This crisis has the potential to do something similar, but we do expect this to be in part dependent on how the war in Ukraine develops. We do not expect far-reaching reforms of the SGP that would exclude investments at this point, so if indeed the war results in groundbreaking decisions, we would expect it to be in some form of joint debt issuance.

Fiscal policy will remain accommodative in the years ahead but not excessively accommodative. The age of austerity is over, but prudence is not out of the door. We expect some rebalancing of government spending to happen, but not actually leading to tightened policy stances in the medium-term. And how accommodative fiscal policy can then become depends on whether defence and energy independence spending is funded centrally or not, whether there will be substantial SGP reform and whether the European Central Bank continues to be an important player in the bond market. Our best guess at this point is that a SURE-type lending programme will be introduced. This fudge allows governments to structurally invest at low rates. The fact that this does add to national debt continues to force governments to reform and remain prudent in other spending. This still demands significant SGP reform, but with low interest rates locked in, EU leaders can afford to kick the can down the road with that issue for some time to come.