Fiscal Challenges Within the Eurozone

This report is based on Morgan Stanley's "Can Europe Fund Its Future Without Adding Debt?" Which can be found at: https://shorturl.at/FRofC

On the 11th of June 2026, John Healey quit as a defence secretary after a battle in government over lack of military funding. Now, despite common rhetoric pointing towards Ed Miliband or Shabana Mahmood being appointed chancellor, John Healey himself has been selected to lead the Treasury. 10-year gilt yields rose from around 4.95%to around 5.05%on the day; however, this mainly arose from Andy Burnham's comments on the "flexibility" of the fiscal rules. This report will analyse the broader trend of Europe's financial vulnerability, with a specific focus on the UK's economy and why, regardless of promises outlined by Burnham, bond markets are anxious.

"Borrowing cannot be the only answer. Markets will reward plans that boost growth, not debt," says Jen Eisenschmidt, Chief Europe Economist at Morgan Stanley Research. Morgan Stanley Research expects governments across the region to make tough budget choices that support growth without increasing debt. This comes as Europe enters a new fiscal era of ageing populations driving pensions costs higher, interest rates increasing debt repayment costs and geopolitical tensions requiring higher defence spending. Currently, in three of the four largest eurozone economies - France, Italy and Spain - public debt is already above 100% of GDP. Furthermore, the UK faces pension and defence spending as a percentage of GDP rising by around 1.4 pp by 2040, while costs to service debt are already above pre-pandemic levels.

These statistical insights highlight the need for outright fiscal alteration; however, pension payments, healthcare, defence, public safety and interest expenses are difficult to reduce and in many cases are expected to continue rising. "A more feasible route would be to slow the growth rate of some expenditures, allowing them to decline as a share of GDP over time." Eisenschmidt says. Morgan Stanley Research has recommended potential policy measures that may likely be implemented by Eurozone countries:

• Gradually slowing the growth of selected government expenditures by limiting increases to the rate of inflation. This is not a cut, as nominal spending still rises every year, so it's politically easier to sell than austerity. However, the current economic outlook of around 1.1% growth and 2.3% inflation (according to OBR estimates) stresses how the inflation-cap strategy stalls and spending wouldn't fall much as a share of GDP. Without strong growth, "reallocating, not cutting" runs out of room fast.
• Protecting public investment, including infrastructure projects that can improve long-term productivity. This strategy has already been implemented within the UK, as the key "stability" rule implemented by Rachel Reeves and which will be continued under John Healey requires that only the current budget be in balance or surplus by 2029/30. Investment sits outside of this entirely and allows for key investment into areas promoting long-term growth.
• Strengthening Europe's defence-industrial base by directing more procurement toward domestic suppliers.This is a strategy used extensively by the United States with the 10 U.S.C. 4872 provision: Requires contractors seeking waivers to prove exhaustive efforts to find domestic alternatives and provide strict timelines to onshore production. Europe has a similar procurement framework under the European Defence Industry Programme but may need to be strengthened.
• Reforming pension savings systems to encourage greater household investment and deepen local capital markets.This is currently completely voluntary within the UK and is quite debated. Currently, 17 workplace pension providers, managing around 90% of active savers' DC pensions, have signed a voluntary agreement to invest 5% of their default funds into the UK, expected to mobilise 50bn of capital into UK assets. Despite this, making a law forcing pension funds to invest in the UK could lead to capital misallocation and potentially to more risk through propping up underperforming domestic assets. (https://shorturl.at/dZt1S very good podcast episode on this)
• Encouraging private investment in sectors with higher long-term growth potential.A good example of this occurring is within the UK, as the government has secured over 100bn in private investment into UK clean energy plans and projects since July 2024. This reduces the need for government spending in these areas, as private companies take on the capital cost and risk of the underlying projects.

But why does this matter? Homing in on the UK, public sector net debt stood at 94.9% of GDP at the end of June 2026, according to the ONS, with total welfare spending accounting for 23.6% of the total amount the government spends in 2025 to 2026. With debt levels this high, there is a potential fear from bond vigilantes over the UK's fiscal prudency. As bond yields are hovering around the 5% mark, any further geopolitical shocks (such as a worsening of the oil crisis or Trump's recent tariff announcements) could lead to yields rising higher. With the Resolution Foundation estimating that the fiscal headroom has shrunk to around 10bn - for context: this would put the new Chancellor's headroom at a historical low relative to the recent average of 29 billion held between 2010 and 2024 - there is a risk of potentially breaking the fiscal rules and leading to further pressure from the bond market to cut spending by demanding higher yields on bonds.

The first policy announced by Andy Burnham during his first speech as Prime minister was to eradicate rough sleeping, a policy he had enacted in his time as Mayor of Manchester. He recently is also planning to cut business rates on nightclubs, pubs and music venues, while also looking at increasing the tax-free allowance. All these policies would massively help the UK economy, but with the fiscal backdrop he has unfortunately inherited, how he will fund this is still unclear.