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Europe Doubles Down on Big Government

Economists fear high inflation and rising interest rates will make it harder for the continent to spend its way out of this downturn

Government spending in France as a share of economic output is now the highest in decades, excluding the pandemic years of 2020 and 2021.

By Tom Fairless, WSJ

Updated Nov. 9, 2022 7:24 am ET

FRANKFURT—Europe’s answer to its latest economic crisis: even bigger government.

Faced with soaring inflation and an energy crisis caused by Russia’s attack on Ukraine, European politicians are adding hundreds of thousands of public-sector jobs, guaranteeing business loans, subsidizing energy bills and splurging on infrastructure, defense and key industries.

Spending by eurozone governments is expected to reach 51% of the region’s economic output this year, around 4 percentage points higher than in 2019, according to the International Monetary Fund. In Germany, France and Italy, government spending as a share of economic output is now the highest in decades, excluding the pandemic years of 2020 and 2021.

In the U.S., state spending surged to 45% of gross domestic product in 2020, at the height of the Covid-19 pandemic, but has since declined to 37% of GDP, close to its precrisis level.

State intervention is one reason Europe’s economy has held up relatively well this year. The eurozone economy grew at an annualized rate of 0.7% in the three months through September, showing resilience to the historic shocks rocking its energy markets. Even Germany, whose energy-hungry industrial businesses are particularly vulnerable to the recent surge in gas prices, recorded modest growth. While government spending dragged down growth this year in the U.S., it supported growth in the eurozone, according to data from JPMorgan.

The European Union’s executive arm on Wednesday proposed a loosening of the bloc’s debt rules that would give highly indebted governments more room to spend money. The bloc normally requires governments to keep the budget deficit below 3% of GDP and debt below 60% of GDP. But it has suspended those rules for four years in a row through at least the end of next year to allow governments to spend more freely.

One area where government spending has been felt most directly is the labor market. Public-sector employment across the eurozone has risen 4% since 2019, compared with a 1% increase in market-services jobs and a 1% decline in manufacturing jobs, according to European Central Bank data. One in four eurozone workers was employed by the state last year.

In Spain, the public sector added about 52,000 jobs in the three months through September, more than double the number of new private-sector hires in that period, the national statistics agency said.

In the U.S., the number of government jobs has dropped more than 2% since early 2020, while private-sector job numbers have grown 1%, according to data from the Bureau of Labor Statistics.

In the U.S., “there is a countering logic [that the government] spent so much money during the pandemic that now we need to save,” said Jacob Funk Kirkegaard, senior fellow at the Peterson Institute for International Economics, a Washington think tank.

After the financial crisis of the late 2000s and the ensuing eurozone debt crisis, Europe also tightened its belt, he said, but not this time around, even though rising interest rates and market turmoil are making it harder for governments to deepen public debt.

For now, Europe’s state-driven splurge is helping to delay and alleviate the economic downturn and might even help control inflation in the short term. But economists worry that this approach also carries risks.

Unlike during the financial crisis, the eurozone crisis and the pandemic, free-spending governments are on a collision course with the ECB, which has raised interest rates at its fastest-ever pace to cool inflation. The eurozone’s inflation rate rose to 10.7% in October, a fresh high, while price growth in the U.S. slowed to 8.2% in September.

The IMF last month urged Europe to cut state spending to support central banks in the fight against inflation and to replenish empty treasuries. “Clearly, there is room to provide support for vulnerable people at lower cost,” Alfred Kammer, director of the IMF’s European department, told a news conference in Washington.

Across Europe, governments have recently revived large-scale loan-guarantee programs to support companies hurt by the fallout of Russia’s war, according to data from Bruegel, a Brussels-based think tank. In Italy, one-third of all outstanding business loans by value are backed by the government, according to an August report from the IMF.

While such sweeping support for business made sense during the pandemic, the case is less clear now because changes to energy supplies are here to stay, said Nicolas Veron, a senior fellow at Bruegel and at the Peterson Institute for International Economics in Washington.

Europe’s recovery has been slower than that of the U.S., with weaker investment. The eurozone economy likely is about 4% bigger this year than it was in 2019, when measured in dollars, while the U.S. economy is about 17% bigger, according to IMF data. Capital investment in the eurozone increased about 4% last year and 3% this year, while in the U.S., equipment investment surged 10% last year and 5% this year, according to JPMorgan.

Still, government intervention is proving popular in Europe. From Berlin to Paris to Rome, voters have recently elected governments that have promised more support. During his re-election campaign this year, French President Emmanuel Macron pledged to build 100% French supply chains in the next five years for electric cars, offshore wind farms and solar panels.

In Italy, Prime Minister Giorgia Meloni’s new government is planning to raise the budget deficit to 4.5% of GDP next year. Italy’s government debt-to-GDP ratio has risen to 150% from 135% in 2019.

In Germany late last year, voters elected a coalition centered on the left-leaning Social Democrats, which promised to spend big to reshape industry.

“We all know we are on the verge of a second industrial revolution,” German Chancellor Olaf Scholz told the nation’s parliament in June as he unveiled new spending plans worth about €200 billion, equivalent to about $200 billion.

The shift toward big government raises uncomfortable parallels with the 1970s, when advanced economies sharply increased state spending and debt during a period that was accompanied by high and stubborn inflation.

Amid supply bottlenecks, high government expenditure “can exacerbate inflationary pressures and force the central bank to tighten policy [or increase interest rates] by more than would otherwise be necessary,” ECB President Christine Lagarde warned in a speech on Friday.

The ECB has raised its policy rate by 2 percentage points since July, to 1.5%, the highest level in over a decade. That is pressuring indebted European countries like Italy, whose 10-year bond yield has surged to about 4.5% from 0.9% a year ago. Politically, too, the fact that richer countries like Germany can afford bigger subsidies is creating tensions in Europe’s currency union.

While forecasts for the depth and duration of the projected downturn vary widely, a particularly deep recession could stretch European public coffers even more. A sharp recession could happen if a cold winter triggers energy rationing, forcing businesses to shut down across the continent.

“Debt sustainability problems seemed theoretical when interest rates were zero,” but the discussion is coming back as interest rates surge, said Gaurav Ganguly, senior director of economic research at Moody’s Analytics in London.

The British government last month scrapped a program of tax cuts after investors took fright. “What happened in the U.K. shows that markets are on high alert for sustainable policies,” said Klaas Knot, who sits on the ECB’s rate-setting committee as president of the Dutch central bank. He warned that governments’ spending policies must remain sound and their budget deficits must adjust to the changed interest-rate environment.

“Over the next five years I expect several episodes of market panic and spiking spreads for certain eurozone sovereigns,” said Sony Kapoor, a finance professor at the European University Institute in Florence, Italy.

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