The IMF appears to be warning of the risk of public debt explosion in Europe by 2040, while also explaining the reasons. Specifically, increased spending pressures across a range of sectors, as well as high borrowing costs, are key reasons why debt could increase in Europe, at a time when according to an IMF report from last October, global debt will exceed 100% of GDP by 2029.
According to the IMF report, the pressures relate to spending on healthcare and pensions, defense and climate change, and it is estimated that overall they will increase the level of public spending in developed economies by an average of about 4.5 percentage points of GDP by 2040. It is noted that specifically for the countries of Central, Eastern and Southeastern Europe, they are expected to increase by 5.5 percentage points of GDP.
IMF: Debt trajectory will not be sustainable without measures
If no measures are taken, the IMF estimates that the debt trajectory will not be sustainable and on average will reach 130% of GDP by 2040, meaning it will almost double compared to current levels. If debt is weighted by countries’ GDP, it is estimated that it will reach 155% of GDP as some of the largest European economies have the highest debt ratios, while it is emphasized that the debt trajectory could be even more adverse if the deterioration of the fiscal position slowed the already anemic economic growth and further increased borrowing costs.
The IMF report also notes that the conclusion from economic literature is that public debt reduces growth, especially when it reaches high levels. This is due to the fact that higher debt can lead to higher interest rates on government bonds, among other reasons due to reinforced inflation expectations, which makes financing conditions more difficult and crowds out productive investments, can also lead to expectations of higher taxes in the future, limiting investments or create risks for financial stability due to banks’ exposure to public debt.
On average, relevant studies find that an increase in the debt/GDP ratio by 10 percentage points reduces annual GDP growth by about 0.05-0.2 percentage points when debt exceeds 75% of GDP.
Taking this into account, the International Monetary Fund estimates that the increase in debt, without taking corrective measures, could slow the annual GDP growth rate by about half a percentage point by 2040, which is significant given the potential growth rate of about 2% on average across all European countries, while in turn, the lower growth rate and higher interest rates would cause deterioration in debt dynamics and the average debt ratio would reach about 150% of GDP by 2040 (or close to 190% weighted by GDP).
What Europe needs according to the International Monetary Fund is an ambitious policy to address the explosive increase in debt, which will include both reforms and fiscal consolidation measures.
The three pillars on which the IMF’s policy for Europe could be based
This policy should be based on three pillars:
First, reforms that will increase the government’s ability to address pressures by strengthening economic growth (for example, reforms in the product market, labor market and governance, as well as a deeper single market of the European Union), will address certain spending pressures (for example, by adapting pension systems to mitigate the cost of aging and life expectancy extension) and will relieve the burden on national budgets.
Second, medium-term fiscal consolidation measures, both on the revenue side and on the expenditure side. These could include revenue mobilization, through tax policy reform and improved revenue management, as well as stricter prioritization of spending and improvement of its efficiency.
Third, in some countries, the report notes, more radical fiscal measures may be needed that could include reassessing the scope of public services.
