The Trump trade wars are now in full swing, it seems. Steep US import tariffs took effect on goods from Canada, Mexico and China, though some of it was paused again.
The uncertainty remains. The European Union (EU) is likely to be next, especially since US President Donald Trump seems to believe that the EU was created to rip off the US. In fact, the EU and its predecessors were created with US support both to prevent a repeat of the catastrophic wars of the first half of the 20th century, and to be a bulwark against Soviet expansion.
Today, Europe runs a large goods trade surplus with the US, meaning that it exports more than it imports, particularly cars, machinery, pharmaceuticals and chemicals. This is like a red flag to a bull for Trump. But it misses half the story. Europe imports more services from the US than it exports to it (think consulting, financial services and software). European investors have also poured money into US markets, meaning that the US ‘exports’ financial assets to Europe. Trump, however, only seems to care about goods deficits, partly because his typical supporter is more likely to be a blue-collar worker in a factory than a white-collar worker in a multinational bank.
US tariffs on European goods will hurt the latter’s economy at a time when growth has been tepid. The US is its largest external trading partner, though trade between EU countries is around 1.6 larger than trade between the EU and non-EU countries (this is a big lesson for Africa). If Europe retaliates with tariffs of its own, it will disrupt the trading networks that developed and deepened across the Atlantic over the past eight decades, a period when the US and Europe were close allies.
Shock and awe
However, the biggest shock has probably not been on the economics side, but rather in the realm of security. Trump’s lukewarm views on NATO point to a shrinking of the American security umbrella that currently stretches over Europe. His apparent siding with Russia over the war in Ukraine jolted European capitals. That Europe should take more responsibility for its own defence is correct. That the US should abandon Europe altogether and in fact seem rather hostile to it while cozying up to Russia instead would be a profound shift in geopolitics. As with many things Trump-related, it remains to be seen what substance is and what is theatre.
The fascinating thing, then, is that European equity markets have been on a tear higher since the start of the year, while the S&P 500 has given up all its post-election gains. More on this below.
Chart 1: European and US equities
Source: LSEG Datastream
Collectively, Europe is a massive economy, only behind the US and China and with a population of more than 500 million mostly affluent people. The problem is that unlike the US and China, it is not unified politically or culturally. It is an economy, but not a country, though even the economic unity lacks in important areas.
Not all European countries belong to the 27-member EU (notably Norway, the UK and Switzerland), while only 19 EU members use the common currency, the euro. Sweden, Denmark and Poland, among others have kept their national currencies. Austria is a member of the EU and the euro area, but not of NATO, while Sweden and Finland only joined NATO in 2024. Turkey is a member of NATO, and its football teams play in UEFA competitions, but it has given up its long-standing goal of joining the EU. It remains a matter of debate whether it is really part of Europe or not. Similarly, Russia straddles two continents, but its economic and political centre of gravity is on the European side. The invasion of Ukraine, however, means it now stands firmly in opposition to the rest of Europe as a menacing threat. Ukraine itself is not an EU member but aspires to be. For this note, therefore we’ll use the term “Europe” quite broadly, though clearly there are cases where these distinctions matter. During the European debt crisis of 2010 to 2012, for instance, it mattered greatly which countries used the euro currency and were therefore at risk of a destabilising exit from the euro area.
Fragmented
Though there are overarching and shared institutions, in key respects, each European country retains sovereignty and still sets its own agenda. The biggest problem areas are fragmented capital markets and military spending. Though there are pan-European benchmarks, each country has its own stock and bond markets. Some of these are quite small, limiting the pools of capital available for ambitious firms to fund their growth. Many of the few exciting tech start-ups in Europe have opted to list in the US instead, for instance. The lack of a single Europe-wide bond market is also a big problem for the international use of the euro compared to the US, whose massive and liquid bond market makes the dollar attractive for global reserve managers. The market for bonds issued by the EU is growing in the wake of the pandemic response fund, NextGen EU, which will raise up to €712 billion, but that is still small compared to markets of individual countries. Therefore, most investors in euro-denominated bonds are picking up country specific risks (Germany versus. Greece or Spain versus France, for example) that they might not necessarily want.
On the military side, Europe has plenty of financial and manufacturing muscle, but it doesn’t translate into warfighting capability. Again, each country has its own defence force, with independent strategies and preferences for hardware. There is insufficient coordination and standardisation, which means reduced interoperability between weapons systems. Europe should have a much stronger defence force than Russia, with an economy 10 times and population three times larger. However, it doesn’t. Russia benefits from scale and each rouble spent on military hardware goes further than the corresponding euro spent in Europe. It also retains its Soviet-era stockpile of nuclear weapons. A strong military is also a national priority in Russia, but not in many European countries. Some, like Poland, do take their defensive capabilities seriously, while others clearly do not spend 2% of GDP on their militaries, the target set by NATO.
Click here to read more...
Get the latest issue of FAnews