Existing fiscal governance indicators, such as structural balances and cyclical adjustments, tend to treat geopolitical shocks as mere external noise in cyclical fiscal processes. This article presents a geopolitical fiscal exposure framework, which assesses a small open economy's fiscal results as influenced by both traditional fiscal fundamentals and three geopolitical exposure channels: energy dependence, security and alliance commitments, and the concentration of liabilities in strategically important sectors. The framework is exemplified through Portugal's 2026 budget, where strong prior fiscal performance was disrupted when two exposure channels were triggered simultaneously.
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The study observes that conventional fiscal governance terminology has become inadequate as it is based on a domestic business cycle model. In reality, small open economies can face simultaneous geopolitical threats that impact their fiscal health—such as crises abroad affecting energy costs and increased defense expenditures driven by alliance commitments. This article seeks to reformulate EU fiscal surveillance by incorporating an explicit consideration of geopolitical exposure, rather than relegating it to residual adjustments for temporary or one-off measures.
Within this context, the structural budget balance remains a key indicator for EU fiscal surveillance, yet the cyclical adjustment process assigns deviations solely to discretionary policy or output gaps without accounting for geopolitical shocks. Treating these shocks as only “temporary” obscures critical analytical challenges.
The framework draws upon four core areas of international political economy literature. These include the idea that power structures—such as security and economic links—govern state capabilities (Strange, 1988), and that monetary systems can expose economies to external shocks (Kirshner, 1995). The term “geoeconomics” identifies economic outcomes shaped by geopolitical factors, illustrating how global conflicts can indirectly lead to fiscal crises (Blackwill and Harris, 2016). Moreover, networked interdependencies create vulnerabilities that can be exploited, particularly in energy supply and defense sectors (Farrell and Newman, 2019).
GFEF posits that a small open economy's fiscal outcome is jointly determined by two traditional fundamentals (debt levels and primary balance history) alongside three exposure channels. Although these channels define the impact of external shocks on fiscal performance, the strength of a country's fiscal space can mitigate but not completely neutralize the fiscal effects from geopolitical shocks.
The article analyzes Portugal’s budget for 2026, which highlighted improving fiscal indicators despite experiencing dual exposure shocks—namely, severe winter storms and an energy crisis linked to Middle East tensions. Despite a strong fiscal track record leading to a significant budget surplus in 2025 and a decline in public debt, the initial months of 2026 saw a cash deficit that already exceeded the year’s target. This illustrates how even robust fiscal positions can falter under geopolitical pressures.
The findings from Portugal are contextualized within a broader analysis of a seven-country euro area panel—comprising Portugal, Ireland, Spain, Italy, France, Belgium, and Greece—exposed to the same geopolitical energy shock. Preliminary results showed significant variability in fiscal outcomes, closely aligned with differing fiscal space fundamentals rather than exposure levels themselves.
The article advocates for EU fiscal governance to evolve. It suggests that the reformed EU framework may implicitly shift towards a fiscal space-centered view, especially with recent changes prioritizing expenditure rules. Nonetheless, the framework currently lacks mechanisms to differentiate between geographical-driven fiscal deviations and normal cyclic deviations.
If GFEF's exposure channels yield significant empirical results, EU fiscal governance should incorporate systematic assessments of energy dependency, set defense spending, and strategic liabilities that explicitly account for geopolitical influences. This would enhance the current structural balance assessments and provide a more comprehensive understanding of member states' fiscal vulnerabilities.
With future amendments to defense spending requirements under NATO, the framework outlines the need for a detailed analysis of how geopolitical commitments affect fiscal policies in different member states. As Portugal's experience and that of other euro area economies indicate, the time has come for EU policymakers to proactively integrate this analysis into their fiscal strategies, as geopolitical considerations cannot be overlooked in today’s complex global environment.