Two Largest European Economies Seek Solutions

The two largest economies of the EU – France and Germany – are signalling trouble, creating ripples of concern beyond their borders. France's new government faces the challenge of increasing fiscal pressure to deal with its budget deficit. This will likely slow down France's economy, which is currently growing at the same pace as the EU's overall economy. Meanwhile, Germany's economy is stagnating, and a contraction of 0.2% is expected by the end of 2024. This will negatively affect the EU's overall performance, as Germany's downward trend is forecasted to worsen in the second half of the year.

On 7 October, EU finance ministers held a meeting where one of the main topics was France's failure to meet the EU's budget deficit requirements. While France's economic growth remains relatively stable, Germany has been facing economic difficulties since spring, and this is expected to worsen, according to a forecast due to be released on Wednesday, 9 October.

The importance of these two leading nations to the EU is illustrated by one statistic: 41%. This is the share of Germany and France's combined GDP in the total GDP of all 27 EU countries. In 2023, the EU's GDP stood at €17.1 trillion, with Germany contributing €4.185 trillion and France €2.822 trillion.

The condition of the EU's two largest economies significantly impacts the union as a whole and each member state. Currently, the EU's situation is less than favourable. According to the IMF, global economic growth reached 3.3% in 2023. Growth is expected to slow slightly to 3.2% in 2024, with a rebound to 3.3% in 2025. In contrast, the EU's economic growth is far slower, with only a 0.4% increase in 2023 and a forecasted growth of just 0.2% in 2024. The European Commission projects that EU growth will pick up to 1.5% in 2025.

Thus, the EU has slowed significantly compared to the rest of the world, largely due to inflation control efforts and other factors. The slowdown is particularly pronounced in the bloc’s two largest economies.

How Much Can Be Spent and Borrowed

According to EU agreements, member states are committed to keeping their budget deficits below 3% of GDP and their national debt below 60% of GDP. In France, these indicators are cause for concern, as they significantly exceed the set limits. Such overspending affects the terms at which creditors, from international banks to small investors in government bonds, are willing to lend to the government.

Last year, due to a decrease in tax revenues, France's budget deficit increased sharply compared to 2022 – from 4.8% to 5.5%. This is almost double the EU limit of 3%. Credit rating agencies have responded by slightly downgrading France's credit rating: S&P Global Ratings downgraded the long-term sovereign credit rating from "AA" to "AA-" in May 2024, and Fitch Ratings made in April 2023.

France's national debt is also concerning. Even before 2020, the country's debt-to-GDP ratio was 97.9%. The need to combat the effects of COVID-19 forced France to increase its national debt substantially, with the debt-to-GDP ratio jumping to 114.9% by the end of 2020. By the end of 2023, this ratio had fallen slightly to 110.6%, but it remains high, and credit rating agencies are taking notice.

Although an "AA-" rating is still strong, the high level of debt is worrying. By 2024, the debt-to-GDP ratio is expected to rise again to 112.5%, with projections of nearly 114% in 2025. The economy's recovery has slowed, while interest rates on new government bonds have risen.

In July, Brussels began talks with France to address these issues, primarily the size of its budget deficit. However, following early parliamentary elections and a change in government in France, the deficit problems only began to be addressed in October 2024. Ahead of the 7 October EU finance ministers' meeting in Luxembourg, French Finance Minister Antoine Armand announced his plan to reduce the country's deficit. It is expected that France’s 2025 budget will comply with the EU's new spending rules, requiring the country to cut spending and introduce new taxes.

According to Armand's intentions, France’s deficit should be reduced to 5% of GDP in 2025, down from 5.5% in 2023, with a target of below 3% by 2029. The European Commission forecasts that France’s deficit will reach 5.3% this year. Although this is an improvement over 2023, it is still a warning sign.

The fight against the deficit, as outlined by Armand, will involve spending cuts and increased taxes. But it will hinder economic growth. France has not experienced significant growth in recent years, and much of its recent economic performance has been bolstered by preparations for the 2024 Paris Olympics. This boost will disappear in 2025.

The European Commission's forecast for France was published several months ago, before the new government was appointed. After a 0.7% GDP growth in 2023, the forecasts for 2024 and 2025 were modest at 0.7% and 1.3%, respectively. However, with the fight against the budget deficit, the reality could turn out to be even worse than these modest predictions.

Germany Revving Its Engine

As reported by Suddeutsche Zeitung earlier this week, the German government is likely to announce a negative forecast on Wednesday, 9 October. According to the forecast, the largest economy in the EU – Germany – is expected to shrink by 0.2% in 2024. This disappointing figure is expected to be officially presented by Economy Minister Robert Habeck.

Ten days earlier, Bloomberg, citing sources close to the government, reported that the previous official forecast, which predicted 0.3% growth in 2024, would be revised downward, with zero growth being the best-case scenario.

In its May forecast, the European Commission predicted that after a 0.3% contraction in 2023, the German economy would grow slightly by 0.1% in 2024 and accelerate by 1.0% in 2025. The Commission’s conservative but older forecast seems more realistic than the unofficial government sources' predictions from September.

The sluggish recovery of Germany's economy post-COVID-19 can be attributed to several factors, including the aggressive expansion of Chinese imports, which has challenged German manufacturers. Another issue is the stringent adherence to the "green agenda," which has led to rising production costs across various sectors. Additionally, there has been a decline in demand for germany machinery, equipment, and other complex goods from China and other developing countries, mainly due to the slowdown of the Chinese economy in recent years.

"We are at a turning point. After years of the Green Deal, there is now a need to enhance the EU's competitiveness. Improving the basic conditions for private enterprise and innovation must now become a priority," German Finance Minister Christian Lindner stated on X (formerly Twitter) after the 7 October meeting of EU finance ministers.

Fortunately, the German economy has significant room for manoeuvre. The overall budget deficit was 2.5% of GDP in 2023 and is expected to decrease to 1.6% in 2024 and 1.2% in 2025, according to European Commission forecasts.

Germany’s external debt situation is also positive, with a debt-to-GDP ratio of 63.6% in 2023. This figure is projected to fall to 62.9% in 2024 and 62.2% in 2025.

Thus, there is room to stimulate the economy, which has stalled for the aforementioned reasons. Notably, the European Commission's forecast did not factor in the potential increase in government spending on weapons, ammunition, and other goods for the Bundeswehr and Germany's allies.

The German government faces two key challenges ahead: the need to significantly increase defence spending amid war in Ukraine and the preparation for the Bundestag elections in September 2025. The only viable solution is a temporary increase in government spending, though the finance minister will undoubtedly seek ways to cut non-essential expenses, particularly related to the "green agenda."