Trump, China, and Europe’s Triple Economic Challenge

By Krišjānis Kariņš, former Prime Minister of Latvia, now Senior Advisor at KREAB Brussels

Trump will soon be back in the White House. It is clear that he will be enacting a “tough” foreign and economic policy against China, which is considered the main economic and military rival by the US. He’s already promised a 10 percent tariff against Chinese goods, alongside tariffs against Mexico and Canada. But they won’t be the only targets.

The US will most likely also against other trading partners such as the European Union (EU) with whom the US has an overall trade deficit. While Trump framed his Chinese and North American tariffs as targeting drugs and migration, the overall aim of such policy will be to attract investment back into the US to reinvigorate manufacturing there, in an attempt to reverse the outflow of manufacturing jobs over the past couple of decades from the US to locations with lower costs. Tariffs will be a means to increase the price of imported goods, thereby decreasing their demand, boosting local production and bringing jobs back “home”.

While the US maintains a trade surplus in services with both China and the European Union (EU), it has a large trade deficit in goods with both trading partners, which makes its overall trade balance negative in both cases. Trump is intent on balancing out trade flows with its partners and will use tariffs as the main tool to attain this goal. While many economists argue that this will only increase prices for consumers in the US and hamper economic growth around the world, this apparently will not change the economic policy that Trump is intent on enacting.

For Europe, this poses a triple challenge.

On the one hand, US tariff policy will also most likely affect the EU as well, with “blanket” tariffs of 20% currently being discussed on all imports.

At the same time, increased tariffs on Chinese exports to the US (up to 60%) will induce Chinese exporters to move to increase their share of the wealthy EU market with their goods. Thus, EU manufacturers will be squeezed between lower export volumes to the US coupled with greater and cheaper competition from Chinese imports.

The third challenge for the EU in all of this is the current lack of political leadership. Both France and Germany have weak minority governments that limit their ability to take up their traditional role as the driver of EU policy.

While it is heartening to learn that the leaders of the European Parliament have struck a deal to approve the new Commission, in the end, the Commission is only the executive that enacts policy that needs the approval of the Parliament and Council. Since the EU (or Commission) has no equivalent to a “federal tax” as a source of funds, ultimately the largest say about policy goes to the countries that contribute the most to the EU budget. Among those, Germany and France are the clear leaders.

China policy

As the US will move to “decouple” from the Chinese market, it will be placing pressure on the EU to align its policy with its own. This could even be a bargaining chip in tariff discussions.

For quite a few years, the European Council (the meeting place of leaders of EU countries) has been struggling to define a “China policy” that all can agree upon. As Prime Minister, I took part in a number of these curious closed-door exercises.

The difficulty is that different EU countries have different economic exposures to China, which influences their political decision-making. For example, the three Baltic countries have limited economic exposure, while for Germany, China is a huge market for its auto industry, which itself is very important to the German economy. Thus, the EU as a bloc currently is not prepared to respond to Trump’s China policy.

Europe’s response

What is known is that in the event that Trump enacts, say, an across-the-board 20% import tariff on EU goods, the European Commission has a ready response, which is simply a list of US goods that would receive a reciprocal response. In other words, either the US and EU will enter very tricky negotiations, or else we will have a trade war between these two close partners whose trade exceeds $1.3 trillion.

At the same time, the Commission will feel forced to react to increased Chinese imports with additional tariffs, which could be disputed by EU countries with a large export exposure to China. The EU already has tariffs against Chinese electric vehicles of up to 35.3%. Of course, China will also react to EU tariffs with its own increased protectionist and subsidy policy, which in turn will affect EU exports to China, and thus EU economic growth overall.

If Trump’s policy will bring the world back to a state of protectionism and reduced trade flows, then the EU needs to plan how to cope in such an environment.

In a trade war, the US will be able to use a combination of restrictive import tariffs, reductions in federal tax, and an easing of regulatory restraints (most likely including environmental restrictions) to induce private investment to boost domestic growth.

Tax and regulation

While the European Commission can and should start by easing the heavy regulatory framework on business, it has no equivalent of a federal tax. The EU must attempt other measures to induce the necessary private investments to maintain economic growth of its own. The choices are limited: increase Member State payments into the EU budget and redistribute this through EU funds aimed at investment; expand the existing common debt vehicle (in place since the Covid pandemic); or else leave it up to individual Member states to reduce national taxes or come up with other means to induce private investment.

Without strong political leadership coming from France and Germany, it is difficult to imagine the EU institutions agreeing upon a common solution for investment, with a number of countries opposing bigger payments into the budget and/or more common debt. That would mean that Member states would be left to attempt individual measures to attract private investment, which would only increase the existing economic disparity between various countries. Not all EU economies are on a similar footing.

Considering various “state-aid” restrictions and the hitherto unwillingness of the Commission to accept mergers of large companies, the EU is set for a rough period of economic uncertainty at least until after the German elections slated for the end of February of next year. Even then, the outlook afterwards will depend upon how quickly Germany will be able to form a government and how stable it will be. While a politically weak France in the short term precludes the reemergence of a powerful French-German tandem, a strong and stable German government could be positioned to retake the needed political leadership role in Europe.

While trade negotiators may succeed in preventing an outright trade war with the US, the EU nevertheless needs to prepare for a different world where its closest partner, the US, will be putting up increasing barriers to trade. The EU will need to focus strongly on its internal market, not only by reducing barriers and unnecessary regulation, but also by increasing incentives for private investment to secure economic growth. Increasing trade tariffs between the US, China, and the EU will mean that the cohesiveness of the EU single market will make or break the European economy.