Energy shock or fiscal illusion?
An Iran-driven slowdown revives the debate over deficit limits, but not all public debt is created equal. A commentary by Lorenzo Bini Smaghi
The prospect of a sharp economic slowdown triggered by the conflict in Iran has reopened debate over Europe’s Stability and Growth Pact, which requires member states to keep their public deficits within 3 per cent of GDP.
In exceptional circumstances beyond the control of member states — such as severe recessions, pandemics or natural disasters — the EU Council of Ministers, acting on a proposal from the Commission, can activate a “general escape clause”, allowing the rules to be applied flexibly or even suspended altogether.
There is a precedent. Following the outbreak of Covid-19 in 2020, the steep contraction in output — around 6 per cent across the eurozone on average — and the need to let public finances counteract the recession justified suspending the rules.
There is little doubt that the war in Iran qualifies as an event beyond the control of both the European Union and its member states.
However, its economic impact, particularly on growth, remains uncertain. Much will depend on energy prices, which in turn hinge on the outcome of the peace negotiations and the durability of any ceasefire.
If the Strait of Hormuz is swiftly reopened, oil and gas prices could return to more sustainable levels by the summer. This appears to be a priority for the US administration, not least to avoid excessive backlash from domestic voters ahead of the November elections.
In that scenario, the slowdown would likely be limited and manageable, without the need for prolonged fiscal support or tighter monetary conditions.
If, however, commodity prices remain elevated for longer, the downturn could deepen, potentially tipping Europe into recession.
In that case, policymakers would need to assess whether fiscal policy should offset the negative shock — allowing deficits, and therefore public debt, to rise beyond the limits set by the Stability Pact.
To use the now fashionable terminology, the question becomes whether the resulting public debt is “good” or “bad”.
The distinction depends largely on perspective. For politicians, debt is almost always “good”, particularly if it finances support measures that boost consensus ahead of elections. For investors, however, the answer hinges on the medium- to long-term trajectory of public finances.
From this standpoint, the only debt which can be considered good is the one associated with temporary measures — that avoid triggering an unsustainable dynamic and ensure a clear path back to fiscal balance.
Countercyclical policies are the textbook example: they support the economy during downturns and are unwound once growth gets back to potential.
By contrast, if the slowdown reflects a structural shift in energy prices, debt issued to sustain incomes and offset higher costs is, by definition, “bad”.
Public borrowing is not a solution to structural supply shocks. The experience of the 1970s oil crises is instructive: excessive borrowing led to inflation, balance-of-payments deficits and prolonged fiscal instability.
In the face of an external energy shock, the only “good” debt is that used to finance investment aimed at reducing import dependence — notably by expanding domestic renewable energy capacity.
A second factor to discriminate bad and good debt is the initial level and underlying trajectory of public debt. The higher the starting point, and the faster debt rises, the more damaging additional borrowing becomes.
Recent attention has focused on Italy’s budget deficit, which fell to 3.1 per cent of GDP in 2025. Far less scrutiny has been given to the continued rise in public debt, which reached 137.1 per cent of GDP — roughly two percentage points higher than the previous year and four points above 2023 levels.
Forecasts point to further increases in 2026, partly due to the growing burden of interest payments.
In such a context, additional borrowing that delays fiscal adjustment and undermines sustainability can hardly be described as “good” debt.
A first version of this article was published in the Italian daily Il Foglio
IEP@BU does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
