Goldman Sachs: Eurozone Fiscal Response to Energy Price Hikes is Limited; Defense Spending Becomes New Driver

Overview

This Goldman Sachs macro report analyzes the fiscal policy responses of major Eurozone countries (Germany, France, Italy, Spain) to recent energy price increases. The core conclusion is that, compared to 2022, current fiscal support measures are significantly smaller in scale and more targeted. Meanwhile, with the shift in German fiscal policy and the EU's launch of new defense financing instruments (SAFE), the focus of European fiscal policy is shifting from post-pandemic recovery to security challenges. The report forecasts that German fiscal expansion and the final year of Recovery Fund disbursements in 2026 will offset fiscal consolidation in other countries, resulting in a 0.1 percentage point positive contribution to Eurozone growth; however, starting in 2027, fiscal consolidation will regain dominance and drag on growth. Furthermore, although interest expenditures are rising due to high rates and inflation indexation, higher inflation is expected to offset some of this pressure, maintaining relatively stable debt sustainability.

Core views

Limited and divergent fiscal responses to energy prices. The report points out that current Eurozone fiscal measures are primarily temporary and targeted, with overall support levels far below those during the 2022 energy crisis (which averaged 2%-4% of GDP). Strategies vary by country: France is the most reluctant to provide broad fiscal support, deploying only about EUR 1 billion (0.03% of GDP) in measures while offsetting costs with EUR 6 billion in spending; Germany and Italy are mainly reducing fuel excise taxes to lower gasoline and diesel prices; Spain has launched the most generous scheme covering fuel, electricity, and gas prices as well as household income support. Looking ahead, Germany is discussing options for employers to pay tax-free inflation bonuses, and Italy is expected to extend excise tax cuts at least until July, but overall support levels will remain low. Defense spending becomes a new engine for fiscal expansion. With Germany excluding defense spending from its national 'debt brake' limits, its defense expenditure is expected to continue leading. The report forecasts that German defense spending will reach 3.5% of GDP by 2029, while the Eurozone average will reach 2.8%, representing increases of 1.5 and 1.1 percentage points respectively compared to 2024. Assuming at least two-thirds of defense spending will be procured domestically, the report assumes that every 1% of GDP in defense spending will boost real GDP by 0.6%, and this fiscal multiplier may increase further as European capacity expands. EU fiscal programs shift towards security, with debt issuance peaking in 2026. 2026 marks a turning point for EU fiscal programs, signaling a shift from the 'NextGenerationEU' (NGEU) Recovery Fund to addressing security challenges. The Recovery Fund enters its final year, with disbursements expected to stabilize around EUR 100 billion, still the highest level in the program's six-year history. Simultaneously, the EU has approved a EUR 150 billion 'Security Action for Europe' (SAFE) loan facility to fund increased defense spending by member states, and plans to provide EUR 45 billion in annual loans to Ukraine. These factors collectively drive EU debt issuance to a historical peak in 2026. Growth outlook improves before deteriorating; debt ratios diverge. The report predicts that in 2026, German fiscal expansion and Recovery Fund disbursements will offset fiscal consolidation in France, Italy, and Spain, improving the Eurozone's structural fiscal balance by 0.2% of GDP, thereby boosting regional growth by 0.1 percentage points. However, since the multipliers for consumption- and defense-oriented fiscal support are below 1, and fiscal consolidation in other countries will become dominant from 2027 onwards, the fiscal impulse will turn negative again. Regarding debt, the Eurozone debt-to-GDP ratio is expected to rise by 1.1 percentage points this year to 98.0%, and further to 99.6% by 2028. Specifically, Germany and France are expected to see rising debt ratios due to high primary deficits, Italy will remain broadly stable, while Spain, benefiting from continued debt reduction, will see its debt ratio continue to decline.

Analysis framework

The report employs a typical macro-fiscal framework for analysis, first evaluating the intensity and nature of policy responses by comparing the scale of current fiscal support (as a share of GDP) with that during the 2022 energy crisis. Secondly, it uses the concepts of 'Fiscal Stance' and 'Fiscal Impulse' to decompose changes in the structural balance, quantifying the net impact of fiscal policy on economic growth. In assessing the impact of defense spending, it introduces fiscal multiplier analysis, combining assumptions about domestic procurement shares to derive specific contributions to GDP. Finally, by decomposing the debt dynamics equation (focusing on the interest-growth differential, i-g), it analyzes the different impact paths of high interest rates, inflation indexation, and primary deficits on debt sustainability across countries.

Methodology notes

• Macroeconomic framework

  Fiscal Stance and Fiscal Impulse Analysis

  The report measures the net stimulative or drag effect of fiscal policy on the economy by calculating changes in the structural fiscal balance (i.e., the fiscal posture excluding cyclical factors), thereby determining whether policy is expansionary or contractionary.

• Macroeconomic framework

  Debt Dynamics and Interest-Growth Differential (i-g differential)

  The report uses the difference between interest rates and nominal growth rates to analyze the natural evolution trend of debt ratios. If inflation rebounds to offset slowing nominal growth, this differential remains stable, helping to mitigate the debt snowball effect and maintain debt sustainability.

• Industry/Sector Analysis Framework

  Fiscal Multiplier and Domestic Procurement Share

  In assessing the contribution of defense spending to GDP, the report assumes that most spending is used for domestic procurement, thereby assigning it a specific fiscal multiplier (e.g., 0.6). This implies that every dollar spent by the government drives $0.60 in GDP growth, and this multiplier may increase as local capacity expands.

Key data

• Contribution of fiscal policy to Eurozone growth in 20260.1 percentage pointsDriven by German fiscal expansion and Recovery Fund disbursements; turns into a negative drag from 2027 onwards
• Germany's 2029 defense spending target3.5% of GDPAn increase of 1.5 percentage points compared to 2024, not subject to 'debt brake' limits
• Average Eurozone fiscal deficit ratio3.4% in 2025 vs 5.6% in 2021Indicates a more robust fiscal balance sheet currently compared to 2021
• Expected EU debt issuance in 2026Historical peakDriven by the winding down of the Recovery Fund, SAFE defense financing, and loans to Ukraine
• Proportion of inflation-linked debt in France and ItalyApproximately 10%Makes their interest expenditures more sensitive to inflation and high interest rates
• Forecast for Eurozone debt-to-GDP ratio98.0% in 2026, 99.6% in 2028Rising by 1.1 percentage points this year, primarily driven by Germany and France

Impact & implications

The report believes that the current rise in energy prices is unlikely to pose significant challenges to fiscal policies in European countries, as this shock is more temporary and European fiscal conditions are more solid than in 2021. However, the shift in fiscal focus means Europe will undergo a significant rearmament process in the coming years, altering the structure of fiscal expenditure. For markets, attention should be paid to the supply pressure on the bond market from massive EU issuance in 2026, as well as the potential downside risks to economic growth from the resumption of fiscal consolidation after 2027. Additionally, the election cycles in France, Italy, and Spain before the end of 2027 may introduce upside risks to fiscal deficit forecasts, thereby affecting debt sustainability.

Risks

• European election cycle risk: General elections in France, Italy, and Spain before the end of 2027 could lead to upside deviations in fiscal deficit forecasts
• Risk of failed political negotiations: If French political parties fail to agree on a budget, the 2027 deficit may not fall to the planned 4.8%
• German budget execution risk: If Germany fails to implement the required additional consolidation measures of EUR 13-17 billion, the deficit could be higher than expected

What to watch

• Specific details and final approval status of further consolidation measures in Germany's 2027 draft budget
• National allocation plans and fund disbursement progress for the EU SAFE defense financing instrument
• Outcomes of autumn parliamentary negotiations in France regarding budget cuts
• Inflation trends in major Eurozone countries and their impact on interest expenditures and debt dynamics