Europe’s role reversal: The problem economies are now further north

Nowadays, there has been a role reversal. Europe’s three biggest economies are stuck in a cycle of weak growth, leading to widening budget deficits. France is the epicenter of this shift and remains mired in a budget and political crisis, while the U.K. is eyeing tax hikes to try to narrow the gap and avoid spooking markets. Famously frugal Germany and the Netherlands are taking on debt, albeit from lower levels.

Meanwhile, southern countries like Spain have emerged as a rare bright spot for European growth, with governments that 15 years ago faced insolvency like Greece running nearly balanced books.

“The fiscal homework was done in southern Europe in the aftermath of the sovereign debt crisis," said Filippo Taddei, a senior economist at Goldman Sachs. “In each of these countries, the fiscal outlook is remarkably more cautious than in the case of France, or even the Netherlands and Germany."

The role reversal could be an unexpected outcome of the crisis, which forced southern countries like Greece and Portugal to make painful spending cuts as part of bailout packages.

The austerity programs imposed upon southern Europe left deep scars: Greece’s economy is still about a fifth smaller than it was before the crisis, according to International Monetary Fund data. Unemployment remains high across the region. But countries were forced to enact structural reforms like raising retirement ages, streamlining bureaucracy, privatizing industries and overhauling labor laws.

“A lot of the countries doing better in Europe right now are ex-program countries," said Frank Gill, an analyst covering Europe for S&P Global Ratings, referring to austerity programs enforced by either the IMF or European creditors. “They have emerged more resilient compared to the economic structures they had 15 years ago."

Spain’s economy grew 3.5% in real terms last year, according to the IMF, one of the fastest rates in the developed world. Greece grew 2.3%, more than double the growth rate in France and the U.K. Germany contracted for the second year in a row.

A surge in tourism is partly responsible for the outperformance. Southern countries have also received hundreds of billions of euros worth of grants and loans from the European Union, helping to fund underwater sea cables in Italy, electricity grid updates in Greece and the build-out of high-speed internet in Spain.

But Taddei, the Goldman economist, said the economic changes benefiting southern Europe run deeper. Milan, Lisbon and Seville have grown into burgeoning tech, finance and startup hubs. Labor markets once dominated by low-value work are adding skilled jobs that should boost overall productivity.

Governments are also more sensitive now to their spending limits and the potential market consequences of breaking them. Italian Prime Minister Giorgia Meloni came into power in 2022 after campaigning on tax cuts and higher pensions. But the right-wing leader put fiscal caution first to reassure Italy’s fragile bond market. She has since reined in the budget deficit, which is expected to fall below 3% of gross domestic product next year.

That forecast recently drew praise from the IMF. “This is fantastic," Helge Berger, deputy director of the IMF’s European department, said at a press conference. He also lauded last year’s “very impressive" budget performance.

Now, it’s the countries in the core of Europe facing trouble. The growth model of Western Europe—centered on trade and industry—has been rocked by U.S. tariffs, the rise of Chinese competition and the end of cheap Russian energy.

Governments across Europe that borrowed heavily during the pandemic and energy crisis are trying to put their financial house in order. Countries in the south have largely brought deficits back down to where they were before the pandemic, but governments further north, struggling to raise revenue amid weak growth, are heading in the opposite direction.

France is expected to run a deficit of 5.4% of GDP this year, compared with 2.4% before the pandemic. Budget gaps in the U.K., Austria and Belgium are above 4%.

Germany is spending up to 1 trillion euros, equivalent to $1.15 trillion, on infrastructure and defense. That move is likely to boost growth but drive its deficit well above the 3% annual cap that was written into the EU treaty—at the insistence of then-Chancellor Helmut Kohl—that paved the way for the currency bloc.

Spending needs are likely to grow even more in the years ahead as countries face aging populations, defense pledges, expenditures on the green-energy transition and a steep rise in debt interest payments. But so far, attempts to trim the welfare state to accommodate other spending claims are failing.

France has seen three governments fall in the past year over plans to cut spending. Prime Minister Sébastien Lecornu, who resigned in early October but was reappointed a few days later, has announced plans to suspend Emmanuel Macron’s signature pension overhaul that progressively raises the retirement age.

“There’s clearly a recognition that something has to be done," said S&P’s Gill. “The issue is there’s not much consensus on what exactly." The gridlock led S&P to announce a surprise sovereign ratings downgrade on France last month.

Absent economic growth, voters are unhappy and drifting to parties on the far right and left. That increased political fragmentation has made it harder to build consensus for painful economic policies.

“There is a fiscal doom-loop link between very challenging fiscal policy and political stability that is becoming reinforcing," said Mujtaba Rahman, managing director for Europe at Eurasia Group. “In France, U.K., and potentially Germany, the challenges over public finances reinforce political instability that makes it harder to reform these things."

Some question whether massive bond-buying programs carried out by the European Central Bank and others after the financial crisis, and again during the pandemic, are partly to blame. So-called quantitative easing helped economies weather the crisis by making borrowing cheaper for businesses, households and the government. But some economists believe these central-bank backstops create a “moral hazard" for governments, reducing their need to run balanced budgets or deal with mounting debts.

“At the moment, no country has reached the tipping point, in part because the ECB is there in the background," said Rahman. “But reaching the tipping point may be exactly what’s needed to address these slow-building challenges." If they don’t, the risk of a disorderly crisis grows, and so does the potential long-term damage.

The U.K., too, is struggling to address its rising debt and soaring spending. Prime Minister Keir Starmer shelved a plan to pare back some disability benefits this summer after lawmakers in his own Labour Party rebelled. In the coming weeks, the government is set to announce a budget plan that relies largely on tax increases instead of spending cuts. The U.K. government has pledged to balance the budget and bring down its debt burden by the end of the decade, though economists are skeptical those goals will be met.

Mahmood Pradhan, head of global macro at French asset manager Amundi, said European countries aren’t facing an imminent debt crisis. Germany in particular has a relatively low debt burden, at 64% of GDP. France’s borrowing costs have jumped this year—topping Italy’s—but the government has had no trouble finding buyers for its debt.

But he warns countries that overspend now risk tying their hands for future crises.

“The real handicap is that Europe will not have the fiscal space to respond to future shocks," he said. “Governments can’t stand and do nothing, but it’s likely in future shocks, governments will have to take trade-offs seriously."

Write to Chelsey Dulaney at chelsey.dulaney@wsj.com and David Luhnow at david.luhnow@wsj.com