Concerns over government debt have been on the rise, with a growing number of observers and institutions pointing to the unprecedented levels reached in many EU countries. In parallel, there is an even more lively debate about the need to find additional public resources to tackle pressing challenges such as the green transition or strengthening defence. Since higher taxes are considered a political no-go, new public debt, ideally raised at the EU level, is presented as the way forward. This column provides a brief history of government debt in the EU and draws attention to some important issues that are normally kept in the background.
The post-WWII era marked a critical juncture for European nations as they embarked on rebuilding war-torn economies, not least through stronger economic and political integration. Amid this process, in several countries government debt went through a proper roller coaster development. During the early post-war years, most governments were primarily focused on reconstruction while at the same time managing a large amount of government debt accumulated during the war. High inflation and financial repression put debt on a downward trajectory (e.g. Reinhardt and Sbrancia 2011). 1
Figure 1 Gross government debt to GDP (%)
Source: IMF, European Commission
The 1950s and 1960s heralded an era of robust economic expansion, spurred by industrial recovery, the Marshall Plan, and burgeoning global trade. This period allowed many European governments to reduce their debt-to-GDP ratios, as economic growth outpaced the need for further borrowing. By the late 1960s, the countries which some ten years earlier had agreed to form the European Economic Community – the precursor to the EU – all recorded debt levels amounting to less than half of one year’s national economic output (see Figure 1).
This phase of economic recovery created a window of relative fiscal stability. Governments were able to fund infrastructure projects and emerging welfare programmes without significantly exacerbating public debt. However, the economic landscape changed in the 1970s, triggering a sustained rise in government debt that has continued, to varying degrees, across some parts of Europe until today.
The role of the welfare state in rising government debt since the 1970s
The 1970s marked a decisive shift in fiscal policy, as the era of post-war economic stability gave way to new challenges. The primary catalyst for the rising debt-to-GDP ratios during this period was not large-scale public investment in infrastructure but the expansion of welfare programmes. Governments across Europe responded to economic challenges, such as global oil shocks, rising inflation, and unemployment, by expanding welfare programmes to shield their populations from economic insecurity.
The welfare state, which had initially focused on basic social protections, began to grow significantly in scope during this time. Social security systems, unemployment benefits, healthcare services, and pension schemes were all expanded in response to increasing political demands for greater social safety nets. These programmes, aimed at addressing income inequality and providing economic stability, required significant government spending.
Rather than fully financing these expansive programmes with tax increases, governments turned to borrowing. This reliance on debt resulted in a persistent rise in government debt as a share of GDP across much of Europe. While welfare expansion was politically popular and provided short-term relief for citizens, it also placed a long-term fiscal burden on national economies.
Debt financing of the welfare state: Addressing liquidity constraints of low-income constituencies
The expansion of welfare programmes and the associated increase in public debt were not only economic policies but also political strategies aimed at addressing the constraints faced by lower-income constituencies. In many European countries, these groups began to exert greater influence through electoral victories, pressing for policies that would improve their economic standing by drawing on future generations. As a result, debt-financed welfare programmes emerged as a mechanism to alleviate the immediate financial pressures on lower-income households, enabling them to access healthcare, education, and social services.
Originally, the rationale behind these policies was that by improving the consumption and living standards of lower-income constituencies, governments could enhance overall economic demand and stability. In theory, this would lead to a virtuous cycle of social improvement and economic growth so that future generations would be able to foot the bill. However, the reliance on debt to fund these programmes created vulnerabilities, especially when economic growth stagnated or contracted and, more recently, populations started to decline. First doubts about the ‘enjoy now, pay later’ idea started to emerge.
Long-term consequences: Worsening income distribution since the 1980s
Despite the well-justified intentions behind the expansion of welfare programmes, the long-term economic outcomes for lower-income households have been mixed. In many European countries, the accumulation of debt to finance these programmes did not yield the lasting improvements that policymakers had hoped for. By the 1980s, market income distributions began to deteriorate across much of Europe.
Globalisation, technological advancements, and shifts in labour markets exacerbated income inequality, rendering existing welfare programmes less effective at addressing the root causes of economic disparities. While welfare spending helped to cushion the immediate effects of these changes, it did not reverse the growing economic inequality. In many instances, welfare programmes became an increasingly costly fiscal burden, with limited success in effectively altering the economic prospects of lower-income households. The income share of the bottom 50% actually declined over time (Figure 2) and inequality more generally increased.
Figure 2 Income share of the bottom 50% (five-year moving averages)
Source: World inequality database
Moreover, as welfare programmes expanded – in the 1990s also thanks to the peace dividend – in some countries they were not adapted to the rapid changes in global and domestic labour markets. The economic structures that had supported the post-war welfare state were shifting, leaving many traditional policies ill-suited to the new realities. The growing income disparities of the 1980s thus highlighted the limitations of debt-financed welfare spending as a long-term solution to economic inequality or insufficient aggregate demand.
Public debt as a political instrument rather than an economic solution
As the effectiveness of current spending in addressing long-term economic challenges came into question, public debt increasingly transformed into a tool for political stabilisation rather than a mechanism for resolving economic problems. Governments, wary of the political consequences of adjusting welfare programmes or increasing taxes, continued to borrow in order to maintain the status quo rather than investing in the future. 2
This shift in the role of public debt – from an economic instrument to a political tool – became particularly evident in countries facing economic stagnation or political fragmentation. Rather than addressing structural economic issues, governments opted to maintain their large share of current spending and to cut public investment. 3
In many cases, the need to preserve political stability outweighed the long-term economic rationale for debt-financed expansion of current as opposed to capital expenditure. Public debt, once a lever for economic development, now became a tool to navigate electoral pressures and to sustain political coalitions.
Figure 3 Gross government debt to GDP (%)
Source: European Commission
Notes: Countries are grouped based on their average debt levels in 2011-2019. Low debt = EU countries with government debt <= 60% of GDP (in 2011-2019 on average). High debt: EU countries with 60% of GDP > government debt >= 90% of GDP. Very high debt: EU countries with government debt > 90% of GDP.
This reliance on debt to stabilise politics has increasingly raised concerns about the sustainability of government finances in some countries. The 2008 global financial crisis, the subsequent euro area debt crisis, and the Covid pandemic underscored the vulnerabilities of countries that had accumulated high levels of public debt. The euro area/EU interventions during this period were emblematic of the fragility that comes with prolonged reliance on debt to finance the status quo, especially when economic growth falters or remains anaemic and financial markets reassess the risks of sovereigns.
The end of ‘enjoy now, pay later’
The bailouts and EU-financed support programmes also demonstrated how the protracted use of public debt had exhausted its original scope or even undermined its original purpose. They may have staved off the demise of the European Economic and Monetary Union (EMU), but they also underlined that passing down the bill to ‘future generations’ had reached its limits for a number of reasons. First, markets had simply lost confidence in some sovereigns triggering a painful change of course. Short of losing access to markets, countries with high debt who further increase their primary deficit now face an increase in market rates that may even percolate through the rest of the economy, reversing a good part of the desired boost to the economy (Gopinath 2024). Second, EU support programmes work because they are built around guarantees of countries who managed to maintain sustainable public finances (which is just another way of signalling to financial markets that they are capable of servicing new debt). Third, some high-debt countries managed to increase their already high national debt to take advantage of EU support programmes at sustainable rates largely thanks to the successive asset purchase programmes of the central bank. In other words, further debt increases are contingent on the willingness of the ‘frugal’ countries to share their ‘savings’ or the ECB’s willingness to step in whenever “the uniform transmission of monetary policy across the euro area” is at risk.
Both interventions come with important downsides for current generations. For starters, the frugal countries are getting increasingly concerned with the prospect of further economic integration specifically through joint and several EU debt. Just imagine the bliss of the growing populist parties in Germany, Austria, or the Netherlands if their governments were to propose a larger EU budget or genuine EU debt without safeguards against extended transfers to the rest of the EU. In addition, asset purchase programmes by the central bank may stabilise the euro in the short run but will fuel inflation in the medium term and/or push up prices of certain assets. Both are bad news for current generations of lower-income households, for whom debt financing was meant to offer extra breathing space (e.g. Domanski et al. 2016).
All this inevitably comes to a head when new major policy challenges, such as the green transition and the need to strengthen European defence capabilities, entail daunting financing needs of which the government sector is meant to shoulder an important part.
Conclusions
From an economic perspective, there is no doubt whatsoever that a complete and stable monetary union needs a proper and sufficiently big budget with the possibility to issue common debt. The case has been made very convincingly whenever European nation states engaged in prominent programmatic discussions about further economic and political integration, starting with the Werner Report in 1970, the MacDougall Report in 1977, the Delors Report in 1989, 4 the Five President Report in 2015 and, most recently, the Draghi Report. However, alongside this common understanding of what would complete and ultimately stabilise the EMU there is also the reality that EU member states continue to diverge widely in their propensity to run deficits. 5 Even with common EU debt, someone needs to service the debt and ensure common debt remains on a sustainable path.
The agreement on common EU fiscal rules – the Stability and Growth Pact – alongside the introduction of the euro, was meant to protect centralised monetary policy from the consequences of the widely diverging propensity in national fiscal policies. In the wake of the Covid pandemic the EU and the ECB stepped in to help avert more profound repercussions of the persistently divergent propensity to run deficits in the EU proving the fundamental economic principle that there is no free lunch and something eventually has to give.
To overcome the current economic policy dilemma in the EU, member states need to explore a crucial quid pro quo: In exchange for issuing common debt the nation states need to give up a significant part of their prerogative to raise taxes and to run deficits. Without such a bargain using government debt as a way to smoothen government expenditure no longer works over time as intended. In some countries significant amounts of new government debt would simply open macroeconomic valves implying a fairly quick adjustment, especially for lower-income households.
Source : VOXeu
