Is Eurozone debt sustainable?

Yes.

OK, I think you want a longer answer than that, so let’s look at an analysis of the sustainability of Eurozone public finances from 1995 to 2020. And while we are at it, we might want to compare it to the UK and the US.

So many investors, ironically mostly in the Anglo-Saxon world, are obsessed with the Eurozone countries and their unsustainable debt and deficits. To me, this always seems like a case of these investors fighting the last war because the situation has changed dramatically since the European debt crisis a decade ago. Today, Italy and Spain have significantly reduced their deficits and are forecast to run very low deficits of 2% to 3% of GDP for the rest of this decade. Meanwhile, Germany is the only major economy expanding its deficit, as it ramps up infrastructure and defence spending. But nobody would disagree (or at least nobody who knows something about economics) with the statement that if any country can afford to borrow more, it is Germany. Admittedly, though, France’s deficits look unsustainably high.

Meanwhile, the US is on course to run deficits above 7% of GDP for the rest of the decade.

Deficits in major economies

Source: OECD, OBR, Tax Foundation

Indeed, the European debt crisis has done Eurozone countries a lot of good in hindsight. The chart below shows the fiscal response function of Eurozone countries to past deficits and debt-to-GDP levels. The way to interpret these numbers is that a negative number indicates deficits have been reduced after a past increase in either deficits or debt levels. The value itself gives you an idea of how much the deficit changes for a 1% increase in past deficits or debt levels.

Fiscal reaction function of Eurozone countries

Source: Afonso and Coelho (2025)

The main takeaway is that in the Eurozone, deficits tend to decrease after debt levels or deficits increase. Eurozone deficit rules ensure that government debt remains under control in the bloc. What I find particularly encouraging is that the study showed deficit reduction becomes stronger for countries with higher debt levels (>60%) and those with a history of higher past deficits. And debt sustainability has increased materially after 2009, which is simply a reflection of the tighter fiscal rules introduced during and after the European debt crisis.

By the way, this result directly challenges the Fiscal Theory of the Price Level, as the authors point out, but I won’t enter that rabbit hole. You can read my views on that theory here.

Instead, I want to contrast the fiscal responsibility of Eurozone countries with that of the US. A couple of months ago, I wrote about another study by the same authors, which examined fiscal responsiveness across the 19 largest economies. A chart I didn’t show last time is the one below. It shows how fiscal responsiveness has changed by country between 2000 and 2020. As you can see, all Eurozone member countries have become more fiscally responsible (except Germany, which probably struggles to become even more responsible than it always was). But the US, Canada and Sweden have gone the other way.

In particular, the US has become increasingly irresponsible, despite already having large debt and deficits to begin with. Is it any wonder that investors are demanding higher and higher yields on Treasuries to compensate for the fiscal irresponsibility of US politicians? If you ask me, we are at the beginning of another debt crisis, except that it unfolds on the other side of the Atlantic.

Estimated change in fiscal responsiveness 2000-2020

Source: Afonso et al. (2024)