Get your house in order, Europe — or face ‘ongoing decline,’ economists warn

It’s been a topsy-turvy last year for the euro zone with its largest economies, Germany and France, seeing political and economic turbulence that means neither has a budget in place for 2025.

Economists say the trajectory for both countries is worrying, warning that the absence of growth, fiscal imbalances and political intransigence could lead to decline and a loss of standing for Europe, as a whole.

“The situation today is different from the earlier [sovereign debt] crisis insofar as Europe’s most acute problems are no longer concentrated in smaller economies like Greece. Instead, it is Europe’s two most important economies that are struggling,” Neil Shearing, group chief economist at Capital Economics said in analysis in December.

“Europe faces ongoing decline without fundamental reform at its core,” Shearing said, noting that if this is not carried out, “it is difficult to escape the conclusion that Europe’s future is one of very low growth, continuing concerns about fiscal sustainability and a dwindling sense of standing in a world increasingly characterised by a superpower rivalry between the U.S. and China.”

As it stands, neither France nor Germany has a 2025 budget in place amid political infighting that ultimately brought down their governments.

New elections are set to take place in Germany in February, and analysts are placing bets on new parliamentary elections in France next summer. The countries are now operating with provisional budgets, after rolling over their 2024 taxation and spending provisions into this year, and it’s uncertain when either will agree a 2025 budget.

France and Germany contend with different economic challenges, reflecting both the dangers of overspending and of underspending.

France had a budget deficit estimated to hit 6.1% and a debt pile seen at 112% in 2024, according to the IMF. The new government under Prime Minister Francois Bayrou is expected to struggle to get warring deputies on all sides to pass a 2025 budget, just as did his predecessor Michel Barnier.

Germany, meanwhile, faces a snap federal election in February, after the governing coalition under Chancellor Olaf Scholz collapsed in the fall due to divisions over economic and budget policies. Germany’s problem is one of underspending and underinvestment that have led to dwindling economic growth.

“In complete contrast, Germany’s problem is excessively tight fiscal policy,” Capital Economics’ Shearing noted.

“Its so-called “debt brake” significantly reduces the scope for deficit spending even though the German public debt burden is low. With a stagnant economy, Germany would benefit from looser fiscal policy — and since this would almost certainly suck in imports from other countries, this would help support growth (and thus fiscal consolidation) in France and Italy,” he noted.

Economists say that the lack of budgetary plans means that Europe’s major economies will not be able to fully focus on policies aimed at economic expansion, continuing a worrying trend in recent years of anaemic growth.

This has been caused by a confluence of events, such as the war in Ukraine and the rise in energy prices, a factor that has hit energy-intensive industries in Europe, but has also been exacerbated by weaker demand — both in terms of external demand from the likes of China, and weaker consumer demand within Europe — as well as deeper structural problems, such as low productivity growth and a lack of competitiveness.

The European Central Bank has sought to boost economic activity in the euro zone by cutting interest rates, implementing a 25-basis-point reduction in December — its fourth cut this year — to take its key rate to 3%. The central bank said it expected the euro zone economy to notch growth of 0.7% in 2024 and 1.1% in 2025. Inflation in the bloc was seen at 2.4% in 2024 and 2.1% this year.

Risks to economic growth “remain tilted to the downside,” ECB President Christine Lagarde said in a press conference in December, warning of the potential for “greater friction in global trade” and that “lower confidence could prevent consumption and investment from recovering as fast as expected.”

Some analysts, such as Kallum Pickering, chief economist at Peel Hunt, told CNBC that the ECB should be bolder and go for bigger rate cuts in 2025.

Others say rate cuts cannot help with structural problems, such as low productivity growth, and headwinds such as potential tariffs on U.S.-bound European imports to the U.S., which are likely to be introduced by U.S. President-elect Donald Trump.

“Our base case is that Europe will face a pretty difficult year in 2025,” Jari Stehn, chief Europe economist at Goldman Sachs told CNBC, with the investment bank forecasting 0.8% growth for the euro zone in 2025 — compared with 2.5% for the U.S., over the same period.

“There are lots of issues … high energy prices, China slowing, political uncertainty, trade tensions are all negative things,” he told CNBC’s “Squawk Box Europe.” Investors were still looking for potential bright spots in the region, however.

“People are asking about whether in Germany, when there are new elections, we could get some more fiscal support — maybe, we think there’ll be some, but we think ultimately it will be limited,” Stehn said.

“People are also asking whether the European consumer could finally surprise to the upside, the saving rate is high, there’s actually quite a bit of money [that could be spent], but again we think there will be some support but it’s unlikely there will be a big upside surprise.”

Stehn noted that lower interest rates “will help somewhat with savings and boosting consumer spending, and that is one reason why we do actually think that Europe will grow next year, despite these challenges.”

“But at the same time, I think we also have to be realistic that a lot of the headwinds we’ve talked about [such as] energy prices, China, structural things. Cutting rates is not going to fix all of those things,” he said.

“Ultimately, it’s going to be a challenging environment.”