Political instability threatens growth in Europe's economic giants

As recently as November, the European Commission predicted that economic activity in Germany, measured by real gross domestic product, would grow by 0.7% in 2025, and in France by 0.8%. These aren't spectacular results, but they would boost economic growth in the entire eurozone from barely 1% in 2024 to 1.3%. For Germany, even such modest GDP growth would indicate a marked improvement in the economy after two years of shallow recession.

Two months later, the outlook for the EU's two largest economies by GDP appears weaker. According to a group of local think tanks, Germany is facing stagnation. Fresh forecasts from bank economists suggest that the German economy can still expect GDP growth, but only by 0.3% to 0.4% at most. Forecasts for France are slightly higher, indicating growth of approximately 0.5%.

Economists from Berenberg Bank wrote in a report published a few days ago that the eurozone economy was likely stagnant in the fourth quarter and that this weakness might continue into early 2025. They stated that the largest members of the monetary union, Germany and France, were likely to perform particularly poorly due to unresolved fiscal and economic issues weighing them down. Additionally, the economists noted that uncertainty regarding economic policy in both countries was very high, which was especially problematic at a time when both nations required significant course corrections. They emphasized that the eurozone's previously weak links—Spain, Portugal, and Greece—could once again drive its economy.

Pessimism regarding Europe's largest economies is due to the political turmoil in both countries. Germany is awaiting early parliamentary elections scheduled for February 23 at 1 PM Eastern Time. Until then, Chancellor Olaf Scholz remains in power, but his decision-making capacity is limited after his government failed to receive a vote of confidence in mid-December. In practice, the coalition government of the SPD, FDP, and the Greens, led by Scholz, effectively ended in November when Finance Minister Christian Lindner from the FDP left due to a budget dispute for 2025.

Recent polls offer little hope that any of the three main political forces—the CDU/CSU conservatives, SPD social democrats, and the far-right Alternative for Germany—will be able to govern alone after the elections. Coalition talks will likely be necessary, potentially involving smaller groups like the FDP, which may prove time-consuming. Thus, a new government will likely form by spring, and its decisions will have a real impact on the economy in 2026.

In France, the last early elections were held in July 2024, following the European Parliament elections. The far-right National Rally won the latter, while President Emmanuel Macron's party, Renaissance, took a distant second. The president called for parliamentary elections, which were won by the left-wing New Popular Front, with the National Rally taking third place. However, the left did not gain a majority and lacks coalition-building capabilities, making it unlikely to form a stable government in France until at least the next elections. These could occur at the earliest a year after the last ones—and it's unclear if they would bring any change.

Michel Barnier, a former EU Commissioner for Regional Policy and later for the Internal Market and Services, led the first government formed after the July elections, lasting just over two months. His government was the first since 1962 to resign following a no-confidence vote, primarily due to budget disputes for 2025. François Bayrou from the MoDem party, long an ally of Renaissance, became the fourth prime minister in a year in December.

With the current power balance in the National Assembly (the lower house of the French parliament), Bayrou could at any moment share the fate of his predecessor. To avoid this, he softened Barnier's budget plans, which aimed to cut public spending in 2025 by €40 billion ($59 billion CAD) and increase tax revenue by €20 billion ($29.5 billion CAD), hoping to reduce the public finance sector deficit from 6.1% of GDP in 2024 to 5% of GDP that year. Bayrou suggests a €50 billion ($74 billion CAD) deficit reduction because, as he explains, larger savings might hamper the economy.

This situation highlights how political instability can harm the EU's largest economies. Weak governments are incapable of implementing the reforms needed for sustained economic improvement. Both France and Germany urgently require such reforms, though they differ. Although in both countries, governmental collapses resulted from budget disagreements, in Germany, opponents of looser fiscal policies delivered the final blow, while in France, it was their supporters. As noted by Carsten Brzeski, chief economist at ING, in an interview with "Deutsche Welle," "France should become more German, and Germany more French."

Germany and France, once the engines of the European economy, have been sluggish for years. Over the past decade (2015-2024), German GDP grew by 15% in real terms (at constant prices), and French GDP by 19%. Of the EU’s large economies, only Italy has performed worse. By comparison, the U.S. economy grew by nearly 42% over the same period. Germany and France fare even worse in terms of improving residents’ living standards, measured by GDP per capita adjusted for purchasing power parity (which accounts for price level differences). In Germany, this index rose by less than 5% over the decade, in France by 8%, while across the Atlantic, it increased by more than 20%.

The sources of these economies' weaknesses differ. Germany is struggling with an industrial recession, a result of weak foreign demand, especially from China, and high energy prices. Greater domestic demand, including for investment, could be a remedy. The investment needs in Germany, particularly in energy and transportation infrastructure, are significant, highlighted by the Carolibrücke bridge collapse in Dresden in September 2024. Mario Draghi's renowned report on Europe's competitiveness also pointed this out. However, public investments are limited by the so-called debt brake enshrined in the German constitution (it does not allow the cyclical-adjusted budget deficit to exceed 0.35% of GDP). While this has kept Germany's public debt relatively low, it seems to have come at the cost of stagnation.

Holger Schmieding, an economist at Berenberg Bank, wrote in a recent analysis that they expected Germany to modernize its outdated fiscal constraints to allow for sustainable and credible increases in defence and infrastructure spending, as well as business tax cuts. However, he emphasised that this reform should ideally be implemented before the February elections. First, debt brake reform requires a two-thirds majority in parliament. After the elections, mainstream parties might not have such a majority in the Bundestag. Second, the sooner Germany raises defence spending above 2% of GDP, the less likely Donald Trump is to impose high import tariffs on the eurozone—a significant threat to the German economy.

France, on the other hand, is hampered by the looming avalanche of public debt growth, which negatively affects the country's creditworthiness in investors' eyes. Public debt already reaches 112% of GDP; only Italy and Greece are more indebted in the eurozone. Although debt hasn’t grown in recent years, mainly due to high inflation, now that price increases have moderated, government obligations will start climbing again. According to the International Monetary Fund, France's public debt could exceed 120% of GDP by 2028.

In the short term, attempts to stabilize public finances may stifle the economy. They also face social opposition, much like other reforms aimed at enhancing France's competitiveness, such as the already implemented increase in the minimum retirement age. Thus, the French government faces a dilemma: knowing that fiscal policy must be tightened, but being unable to do so.

This lack of governability led the Moody's rating agency to downgrade the French government's credit rating from Aa2 to Aa3 (the fourth level out of 21 possible) in mid-December.

The agency's analysts wrote, in justifying their decision, that they believed France's public finances would be significantly weakened by political divisions, which, in the foreseeable future, would limit the scope and scale of measures aimed at reducing deficits. The financial market issued its verdict earlier. In early December, the yield spread between France’s and Germany's 10-year bonds—the premium investors demand to choose French over German bonds—exceeded 0.9 percentage points, the highest since 2012 when the eurozone faced a debt crisis. That difference remains elevated today.

The fate of Barnier's government underscores the concerns raised by Moody’s analysts and investors. At first glance, his proposals for reducing the deficit seemed balanced. Higher taxes were primarily going to affect large enterprises and the wealthiest households. If even this failed to gain broad political approval, one can hardly expect more decisive actions to do so. There is also a risk that the extreme left and extreme right might reverse some of the already adopted reforms, given their ability to agree on a vote of no confidence.

However, the inability to undertake deep reforms isn't the only cost of political instability. With no budget bill for 2025, the French administration operates based on the 2024 budget. This means, for instance, no adjustment for public sector salaries—which will negatively affect household real incomes and their consumption expenditures.

Finally, it’s worth noting that the disparity between the needs of France and Germany could present risks for Europe. Softening fiscal policy in Germany will be challenging if France is moving in the opposite direction. German politicians might feel compelled to fund a stimulus for the entire European economy, including France. Such tensions could complicate building a unified front against the USA under the Trump administration.