Longer-term challenges for fiscal policy in the euro area

Prepared by Edmund Moshammer

Published as part of the ECB Economic Bulletin, Issue 4/2024.

1 Introduction

In the future, various longer-term challenges are likely to exert pressure on public finances in the euro area. On top of the existing fiscal burdens – as reflected in the high debt ratios in a number of euro area countries, which were exacerbated by the pandemic and the subsequent energy crisis – there are several important longer-term challenges for fiscal dynamics. This article starts by reviewing some of the most important challenges and discussing their fiscal relevance, with a focus on demographic ageing (Section 2), the end of the “peace dividend” (Section 3), digitalisation (Section 4) and climate change (Section 5). Acknowledging the uncertainties surrounding any quantification of these challenges, Section 6 then presents some tentative – purely indicative – estimates of the additional fiscal effort that could be required to ensure the long-term sustainability of public finances in the presence of such developments. The implications of digitalisation are excluded from that exercise, given the particular uncertainty that surrounds their quantification. Section 7 then provides some concluding remarks.

2 Fiscal costs of ageing societies

The euro area is experiencing demographic ageing. The region is witnessing a significant decline in fertility rates, coupled with steady increases in life expectancy, resulting in an ageing population. At the level of the European Union as a whole, average remaining life expectancy at the age of 65 has increased over the last two decades, rising from 17.8 years in 2002 to 19.5 years in 2022.^[1]

This demographic ageing presents challenges for government finances. With the number of elderly citizens increasing relative to the working-age population, pay‑as-you-go pension systems face mounting financial pressures. Furthermore, ageing populations typically require more extensive healthcare services and long‑term care.

Developments in ageing-related public spending vary across euro area countries. The recently published 2024 Ageing Report provides long-term projections for the key drivers of ageing-related costs and their components (which comprise pensions, health care, long-term care and education) in EU Member States over the period 2022-2070.^[2] In the baseline scenario, which assumes unchanged policies, the euro area on aggregate will face an increase in ageing-related expenditure of 1.4 percentage points of GDP relative to today, but this could increase to 4.0 percentage points in a risk scenario. And even in the baseline scenario five countries may need to increase their ageing-related spending by over 3 percentage points of GDP (Chart 1). The increase in the public cost of pensions has the highest variability across countries, given the varied nature of demographics and pension system arrangements at country level (e.g. the extent to which retirement ages are linked to life expectancy). The increased burden of ageing will require policy reforms or structurally increased savings in other areas.

Chart 1

Additional fiscal efforts required owing to ageing populations

(percentages of GDP)

3 Fiscal costs of the end of the “peace dividend”

Russia’s war of aggression against Ukraine has prompted far-reaching discussions on security, military spending and geopolitical stability. NATO members in the euro area have responded to this challenge by announcing and implementing large increases in defence spending, which represents a significant reversal of previous trends. As the Cold War thawed, all major economies reduced their defence expenditure (Chart 2, panel a). The United States and the United Kingdom more than halved their spending, reducing it from over 10% of GDP in the 1950s to less than 5% as of the 1990s. Germany and France, in turn, reduced their spending from over 4% of GDP to less than 2% today. Using this “peace dividend”, governments refocused their budgets, targeting new priorities such as increased social welfare spending.^[3] After Russia’s annexation of Crimea in 2014, all NATO members agreed to spend at least 2% of GDP on defence.^[4] Since then – and especially following Russia’s full-scale invasion of Ukraine – the vast majority of euro area countries have increased their defence expenditure (Chart 2, panel b). If all euro area countries (including those that are not NATO members) were to increase their defence expenditure to 2% of GDP, this would result in an estimated €71 billion of additional spending annually – equivalent to 0.5% of euro area GDP.^[5]

Chart 2

Public spending on defence

a) Long-term decline since the peak of the Cold War

(spending as a percentage of GDP, 1954-2022)

b) Changes since Russia’s annexation of Crimea in 2014

(spending as a percentage of GDP)

Additional defence spending could potentially increase GDP growth in the EU, with positive implications for fiscal sustainability in the longer term, if it (i) is concentrated in R&D-intensive investment, (ii) does not crowd out other productive investment, and (iii) focuses on EU-based sources. According to the European Commission, using EU-based suppliers in defence contracts and, accordingly, shifting towards sourcing defence equipment and services from within the EU’s internal market could stimulate economic growth in the longer term. The Commission recently announced the European Defence Industrial Strategy, which encourages EU Member States to make strategic investments in their defence capabilities while promoting intra-EU collaboration and cooperation.^[6] One of the key pillars of this strategy involves ensuring that defence products are readily available through the European Defence Technological and Industrial Base. This is about incentivising Member States to procure defence equipment and services from EU suppliers, thereby strengthening domestic defence industries, reducing reliance on external sources and enhancing resilience to any potential geopolitical shocks. According to the Commission, this has the potential to support the growth and development of EU-based defence companies, fostering innovation, job creation and technological advancement within the region. It would also produce multiplier effects across different sectors and ultimately increase fiscal revenues.

The economic impact of Russia’s war of aggression extends far beyond the realm of military spending. In the two years since the invasion of Ukraine, EU Member States and institutions have committed an estimated 0.55% of the EU’s annual GDP in bilateral short-term support.^[7] Furthermore, the EU has also established a €50 billion Ukraine Facility covering the period 2024‑27. The World Bank estimates that Ukraine’s overall recovery and reconstruction needs will total around $486 billion over the next ten years.^[8]

Moreover, in 2022 and 2023, governments were also forced to react to the resulting energy crisis and the high levels of inflation that followed. Indirectly, the war in Ukraine triggered a large temporary fiscal policy response at European level aimed at counteracting the high energy prices and the ensuing inflation, thus pointing to the multifaceted challenges posed by the ongoing conflict.^[9] While governments should continue to roll back these energy-related support measures in 2024 to allow the disinflation process to proceed sustainably, the longer-term challenge of improving energy security in the EU will remain.

As the war in Ukraine is still ongoing and the geopolitical landscape is also characterised by instability in the Middle East and other parts of the world, the full long-term fiscal cost of the end of the peace dividend remains uncertain and is very difficult to estimate. For instance, the fragmentation of global trade could have severe implications for producers and consumers alike. If firms restructure their production chains in order to source inputs from countries that are geographically closer, rather than those with the most efficient production capabilities, their production costs will typically increase.^[10] While the indirect fiscal effects are very difficult to quantify, they could be sizeable.^[11] As a result, there continues to be significant uncertainty regarding the long-term fiscal consequences of these developments.

4 Fiscal costs of closing the digitalisation gap

The rising importance of digital value chains and transformative technologies is necessitating substantial investment in digital infrastructure and digital public services in order to maintain competitiveness. Before establishing the Recovery and Resilience Facility (RRF) in 2021, the European Commission estimated the EU’s digital investment gap vis-à-vis the United States and China at €125 billion per year (equivalent to around 0.9% of the EU’s GDP), calling for the resulting costs to be shared between the private and the public sector.^[12] This will involve significant investment in digital infrastructure, particularly telecommunications networks.

In 2022, the EU adopted the Digital Decade Policy Programme 2030, a set of targets and objectives aimed at catching up in the area of digital transformation, supported by public investment. Around 70% of all funding for that programme – €117 billion in total – will come from the RRF, with €16.6 billion having been disbursed to fund the digital transition by March 2024 (Chart 3, panel a).^[13] Under EU rules, at least 20% of all disbursed RRF funds must be spent on the digital transition. However, most Member States are exceeding this minimum threshold in their revised Recovery and Resilience Plans, with country‑specific allocations of RRF funds to the digital transition ranging from the minimum of 20% in Croatia and Slovenia to 48.1% in Germany. The degree of digitalisation still varies considerably across countries. In order to gauge progress towards the targets set, a Digital Economy and Society Index (DESI) has been devised (Chart 3, panel b). This is a composite index comprising 32 sub-indicators, 11 of which are directly linked to the Digital Decade. The short time horizon limits any causal inference, but estimates suggest that there is a significant correlation between DESI scores and GDP per capita, further reinforcing the ongoing Digital Decade agenda.^[14] Digital investment that results in the strengthening of economic growth may, ultimately, also boost fiscal revenues.

Chart 3

Digital RRF expenditure and DESI scores

a) RRF disbursements targeting digital objectives: breakdown by policy area

(EUR billions; as at March 2024)

b) DESI 2023 scores

(as a percentage of target scores for 2030)

5 Fiscal effects of climate change

Climate change poses major fiscal challenges for euro area economies. From the direct costs of extreme weather events to the broader economic implications of transitioning to a low-carbon future, the fiscal impact of climate change is multifaceted and requires comprehensive analysis and action. As outlined in the ECB’s climate and nature plan 2024-2025, central banks will need to improve their understanding of these drivers in order to deliver on their core objectives.

Extreme weather events – which may increase in frequency and severity as a result of climate change – pose immediate and tangible risks. The economic costs of floods, storms, heatwaves and droughts have increased sharply in recent decades, placing a substantial financial burden on governments.^[15] Costs relating to disaster relief, infrastructure repair and healthcare services in the aftermath of such events place strain on public finances, diverting resources from other essential areas. At the same time, the burden of climate change is distributed unevenly across euro area countries. For example, the European Commission’s PESETA IV project estimates that welfare losses from climate change in southern Europe will be several times larger than in the north of Europe, mostly because of higher temperatures and water scarcity.^[16] This uneven burden is further exacerbated by the fact that some countries which have historically suffered significant losses also have large insurance protection gaps.^[17] Against that background, a recent European Commission discussion paper sheds light on the potential fiscal repercussions of extreme climate events.^[18] The paper estimates that in a scenario where temperatures rise by 2°C globally in the long term, eight euro area countries could see their public debt-to-GDP ratio rise by over 2 percentage points by 2032 owing to extreme weather events.

Transitioning to a low-carbon economy entails significant upfront costs and policy challenges. Mitigation measures (such as investment in renewable energy infrastructure, energy efficiency improvements and other emission reduction strategies) require substantial financial resources and long-term planning. Green investment, both public and private, will be essential in order to facilitate the transition to a sustainable economy.^[19] Carbon-pricing mechanisms such as carbon taxes offer a potential source of revenue that could offset some of the fiscal costs of climate policies.^[20] Recent IMF estimates based on a New Keynesian dynamic general equilibrium model suggest that primary deficits in advanced economies could increase by around 0.4 percentage points of GDP over the next few decades as a result of a policy package designed to achieve net-zero emissions in 2050.^[21] However, this assumes that a large share of public spending on green investment and subsidies is financed through carbon tax revenues.

The macroeconomic and financial consequences of climate change and related policies can also have an indirect impact on public finances. The economic consequences of climate change (which include productivity losses, disruptions to supply chains and declines in agricultural output) can dampen GDP growth. The resulting contraction in economic activity can, in turn, erode government revenues and result in higher debt servicing costs. Model simulations conducted by the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) suggest that some euro area countries could experience significant real output losses. When conducting such analysis, the cost of different transition policies^[22] needs to be set against the reduction in physical risks from climate-related events. For instance, in the “net-zero by 2050” scenario, which limits global warming to 1.5°C through stringent climate policies and innovation, real output losses are fairly limited (Chart 4, panel a); however, the costly transition policies lead to spikes in inflation and relatively persistent increases in interest rates (which rise by 1 percentage point on average; Chart 4, panel b). Increases in interest rates tend to reflect the inflationary pressure created by carbon prices, as well as increased demand for investment.^[23] The higher interest rates in the NGFS’s “net‑zero by 2050” scenario are the single most important driver of the long-term interest-growth differential. For instance, for a country with debt totalling 60% of GDP, a 1 percentage point increase in the interest-growth differential would, over time, result in the annual debt service burden rising by 0.6 percentage points of GDP. Naturally, these simulations are based on strong assumptions and contain a large degree of model uncertainty.^[24] Several aspects – including the drivers of rising long-term interest rates and the role of monetary policy – need to be investigated further, and the ECB is actively contributing to those research efforts.

Under EU rules, at least 37% of all RRF funds disbursed must be spent on the green transition. While Member States often choose to spend significantly higher shares (ranging from 37.4% in Lithuania to 68.8% in Luxembourg and Malta), RRF funds can only cover a limited proportion of a country’s climate expenditure needs.

Chart 4

Simulating the impact of climate change under different transition scenarios

a) Impact on real GDP growth rates

(percentage point changes; averages for the period 2024-50)

b) Impact on long-term interest rates

(percentage point changes; averages for the period 2024-50)

6 Cumulative impact

This section provides a rough and purely indicative estimate of the possible fiscal burden arising from the developments described in the previous sections. A single indicator aggregates the various components (Chart 5 and Box 1), estimating the fiscal adjustment that each euro area country would need to implement as of 2024 and maintain throughout the simulation horizon.^[25] The shared long-term target is a government debt-to-GDP ratio of 60% (as referred to in the Treaty) by 2070.^[26] This fiscal gap measure is indicative and requires further analysis and interpretation to reach normative conclusions. Countries will need to ascertain and execute their respective adjustment paths. Moreover, the implementation of more ambitious structural reforms – notably those that support long-term growth – would help to reduce the fiscal burden, which is computed here on the basis of currently projected long-term growth rates. This is also the reason why the issue of digitalisation is not included in this exercise, as the benefits of digitalisation could potentially compensate for some of the fiscal costs incurred.

Chart 5

Overview of fiscal efforts required in response to specific challenges

(percentages of GDP)

Achieving a government debt-to-GDP ratio of 60% by 2070 from today’s debt levels would require euro area governments to immediately and permanently increase their primary balances by 2% of GDP on average (dark blue and yellow bars in Chart 5). 16 euro area countries would require fiscal adjustments just to maintain their current debt levels, with necessary average savings of 1.4% of GDP (blue bars). Going further and reducing debt to 60% of GDP would, on average, require additional savings totalling 0.6% of GDP in the euro area, with high-debt countries having the largest adjustment needs (yellow bars).

The additional challenges discussed above, excluding digitalisation, could widen the euro area’s average fiscal deficit by approximately a further 3% of GDP.^[27] Of those challenges, demographic ageing is expected to result in the largest fiscal burden over the next five decades, potentially necessitating additional spending of up to 4% of GDP for some countries, and 1.2% for the euro area on average. As regards the NATO target for defence expenditure, four of the NATO members in the euro area are already spending the targeted amount of 2% of GDP, while the other 12 face additional burdens of up to 1% of GDP, resulting in an average burden of 0.5% of GDP at euro area level. For the four non-NATO countries – Ireland, Cyprus, Malta and Austria – there is no formal requirement to spend a specific amount on defence. However, Chart 5 plots the gap vis-à-vis 2% of GDP in the light of the changing geopolitical environment.^[28] For climate change, assuming a “net-zero by 2050” scenario which limits global warming to 1.5°C, we estimate an average cost increase totalling 1.1% of GDP at the level of the euro area as a whole. This is driven by the 0.4 percentage point increase in the primary deficit-to-GDP ratio that was calculated by the IMF and the additional interest burden on debt stocks that was projected by the NGFS.^[29]

The necessary fiscal adjustment is large by historical standards, but not without precedent. At the same time, for all of the challenges discussed above, there is considerable cross-country heterogeneity in the required fiscal efforts, with estimates of gaps ranging from 0.5% to almost 10% of GDP. In the past, large fiscal adjustments were mainly observed in response to major fiscal crises and in the presence of sizeable debt overhangs. Belgium, Ireland and Finland maintained cyclically adjusted primary surpluses of over 5% of GDP on average for more than a decade in the 1990s and early 2000s.^[30] In some countries, the fiscal pressures discussed may not strengthen in the short term; however, there is no room for complacency, as the longer the adjustment is postponed, the larger the eventual adjustment cost will be.

Moreover, additional fiscal burdens may well emerge in the medium term. For instance, the model-based simulations used in this article exclude the digitalisation gap, the long-term implications of which are still hard to grasp. Furthermore, one does not need to go back very far in time to find a large fiscal shock appearing out of the blue: the euro area’s government debt-to-GDP ratio increased by a total of 13 percentage points in 2020 in response to the COVID-19 pandemic. At the same time, the simulation of climate change is based on simplified assumptions and on the unlikely premise that limiting global warming to 1.5°C is still feasible. It also does not capture the impact of societal repercussions (such as conflict), tipping points or macroeconomic effects (such as changes to prices and productivity). This suggests that there could be substantial additional fiscal costs associated with climate change.^[31] On the upside, however, the simulation may understate the potential positive economic side effects of increased public spending, such as spending on digitalisation. While the demographic ageing and climate change scenarios are built on a set of internally consistent assumptions, which also capture macroeconomic effects, the modelling of defence spending does not take account of the possible macroeconomic impact (e.g. the potential for the benefits of technological progress to spill over from the defence sector to the wider economy).

7 Conclusions

Issues such as demographic ageing, increased defence expenditure, digitalisation and climate change will result in significant fiscal burdens in the decades ahead. These developments will be challenging enough in isolation, and countries will face all of them simultaneously. Consequently, action needs to be taken today – especially in high-debt countries facing elevated interest rates and the associated risks.^[33] Economic policies should seek to gradually reduce high levels of public debt and prepare for the future, which will also help to ensure a sound environment for the conduct of the euro area’s single monetary policy.