(Editor's Note: In this series of articles, we answer the pressing Questions That Matter on the uncertainties that will shape 2025--collected through our interactions with investors and other market participants. The series is aligned with the key themes we're watching in the coming year and is part of our Global Credit Outlook 2025.)

The EU's reactivation of its fiscal rules should help stabilize sovereign debt in member states. At the same time, by reinforcing low private investment and consumption, the return to austerity could--as was the case for Greece between 2009 and 2013--worsen the outlook for debt sustainability and hence prove to be self-defeating. This is because the EU, particularly Germany, faces structural challenges to its export-driven growth model and underinvests, compared with the U.S. and China.

How This Will Shape 2025

Over the past four years, the cost of providing budgetary support to households and companies to face economic emergencies amounted to about 10 percentage points (ppts) of developed economies' GDP.  For 2024-2027, we project that larger advanced sovereigns will accumulate another 5 ppts of GDP in public debt. Indeed, new spending pressures are emerging for G7 governments in connection with security risks, trade conflicts, and increasing competitiveness. Moreover, the two largest economies in the world, the U.S. and China, are both operating expansionary fiscal policies that include generous subsidies for the private sector, especially in manufacturing. The question for European governments--particularly manufacturing-heavy Germany--is whether they need to match this generous support or continue to cap public debt, as required by EU fiscal rules.

Chart 1

Germany--set to post negative growth for the second consecutive year--has historically been committed to prudent fiscal management.  German policymakers have watched with concern the post-pandemic trend of rising government deficits, which have, in some cases, eroded ratings and debt sustainability in G7 sovereigns, such as France. Yet there is a price to be paid for overly cautious fiscal policy. This is why the austerity versus growth debate has returned.

In Berlin, the current domestic debate primarily focuses on the debt brake rule, which aims to prevent federal deficits exceeding 0.35% of GDP (plus an economic adjustment component) at the federal level and forbids net new borrowing at all lower government tiers. Overall, Germany's fiscal prudence has been, and still is, a ratings strength. The 'AAA' sovereign rating on Germany reflects its strong public balance sheet (we expect gross general government debt to GDP of below 59%), low deficits (we forecast a 2025 budgetary deficit at -1.7% of GDP), net external creditor position, and wealthy and diversified economy.

The question is whether such a cautious fiscal policy--by exacerbating the confidence shock to Germany's even more cautious private sector--will permanently lower Germany's capital stock, and hence its growth potential, to such an extent that it will also undermine the country's creditworthiness and therefore prove to be self-defeating.  So far this year, German households have saved a record 24% of disposable income versus the sub-5% rate in the consumption driven U.S. economy. The propensity for public and private sectors to save at the same time, rather than to consume or invest, is a fundamental reason for Germany's weak growth and explains why Germany is generating large external surpluses with key trading partners, such as the U.S. The European Commission considers these current account surpluses to be evidence of Germany's macroeconomic imbalances, and of low public and private investments.

Germany's private sector invests a large portion of these surplus savings not in Germany, but in the rest of the world--particularly in the U.S.  Among other factors, this is due to tax incentives launched by the Biden administration, lower U.S. energy costs, and the U.S. dollar's status as the preeminent global reserve currency. Germany's preference for investing in factories, laboratories, and training programs in the U.S., rather than in Europe, also helps explain the widening investment and productivity gap between the eurozone and the U.S.

Chart 2

What We Think And Why

The austerity versus growth trade-off is relevant to U.S. and German sovereign credit stories.  The U.S. continues to run large fiscal deficits, which the Treasury has been able to finance at a low cost, not least thanks to the U.S. dollar's role as the preeminent global reserve currency. We project that U.S. general government deficits will likely exceed 6% of GDP by 2026, pending more clarity on actual policy implementation and provided net general government debt rises toward 100% of GDP. In our view, the fiscal profile is the key sovereign rating weakness for the U.S. In contrast, we project Germany's fiscal policy will continue to be tight and remain among Germany's rating strengths. The U.S. dollar's status as the world's premier reserve currency affords the U.S. significant flexibility in its fiscal and external accounts. We expect this status will remain intact, albeit any unexpected efforts to weaken the independence of the Federal Reserve would test this assumption.

Germany's ratings strength--its commitment to prudent finances--could become a ratings weakness if it contributes to low and declining potential growth.  In contrast, growth has not been a problem in the U.S. We consider that the resilience, strength, diversification, flexibility, and wealth of the U.S. economy is central to the 'AA+' sovereign rating on the U.S. To be clear, the U.S.'s historically stronger growth outcomes, compared with Europe, result from more than just favorable fiscal policy. The U.S.'s enormous domestic energy endowment, flexible labor market buoyed by high levels of net immigration, the significant size of capital markets, and the country's rule of law support its vibrant economy. In comparison, Europe's single market is fragmented, with national regulators impeding the potential for cross-border investments, competition, and economies of scale.

Chart 3

What Could Change

In 2025, the political situation in Europe and the U.S. could become more volatile, against a backdrop of geopolitical conflicts and rising trade disputes.  After France's centrist alliance lost its majority following this year's election, the now minority government struggles to pass the 2025 budget. The political landscape in Germany is similarly fragmented, with the country heading toward snap elections on Feb. 23, 2025. Yet German policymakers across the political spectrum remain supportive of free trade, while the U.S. is pulling back from globalization. So far, president-elect Donald Trump has promised tariff increases and tax cuts, but has yet to propose a plan to reduce the U.S.'s large budgetary deficits. U.S. trade tariffs against Europe and other key trading partners could add further pressure to Europe's already soft economy.

Any significant deterioration in economic relations between the U.S. and the EU could increase consensus among European policymakers to finance investments and support reforms--including those proposed by Mario Draghi in his Competitiveness Report--to mitigate Europe's productivity malaise.  The post-election German government could find a way around the debt brake and support joint EU financing efforts, including for Common European Defense (something that the U.K. may also consider supporting). This could increase public investments, advance the Capital Markets Union, and unify Europe's single market for services and labor.

Alternatively, EU policymakers may remain embroiled in domestic policy--unable to reform and invest to rise to the competitiveness challenge.  Under this scenario, the productivity gap between Europe and the U.S. could increase, and public and private incomes, as well as sovereign credit quality, could decline across Europe.

Read More

• Sovereign Debt In Large Advanced Economies: Up, Up, And Away, July 2, 2024