general » How Will Trump’s Policy Choices Affect Europe’s Economy?

How Will Trump's Policy Choices Affect Europe's Economy?
After nearly three weeks in office there is still plenty of uncertainty surrounding Trump's economic policy

Office of the President of the United States @Wikimedia Commons Office of the President of the United States @Wikimedia Commons

 

Since his inauguration on January 20th, 2017, US President Donald Trump has been busy implementing some major campaign promises. Notably he has officially declared the United States’ withdrawal from TPP, signed an order to build “the wall” and, for a time period of about a week before it was suspended by court, introduced a temporary ban on immigration from seven Muslim-majority countries. Still, with regards to Trump’s foreign economic policy, there is still a lot of uncertainty as to where his administration is heading. As things stand at the moment, there are three aspects that are particularly relevant for economic development in Germany and Europe.

 

The important points at a glance:

  • The uncertainty about the economic and foreign policy approach the USA might pursue is having a negative impact on the global investment climate and is thus weakening global growth.
  • Protectionist measures by the USA would reduce Europe’s exports – and therefore dampen growth and employment across the continent. But a policy of economic isolation would have negative consequences for the USA as well, making it doubtful as to whether the world’s second-largest export nation will actually adopt a hardline protectionist approach.
  • Introducing large-scale tax reductions while simultaneously increasing government investment spending would cause a short-term economic upswing in the USA, with rising interest and inflation rates. Europe would benefit from this in the form of higher exports. In the medium and long term, however, taxes in the USA would have to be raised again, while government spending would need to be restricted. This would lead to a recession in the USA, which would have an impact on Europe too.

 

Uncertainty is worsening the global investment climate

 

Nobody can reliably estimate what economic and foreign policy path the 45th President of the USA will pursue. This has created an atmosphere of uncertainty, which is having a negative impact on the global investment climate. Companies will put many of their investment plans on the backburner for the time being, as they are not sure what global economic performance – and therefore their sales prospects – will be like in the future.

 

In the short term, a decline in investment activity would have a negative influence on the macroeconomic demand for goods, because fewer machines would be required, fewer jobs would be created and, therefore, the income gains that would boost private consumer demand would not be forthcoming. In the medium and long term, the lack of investments would mean that production capacities are not expanded. This means that growth would then be weakened on the supply side, too.

 

The exact extent of the resulting decline in growth cannot be quantified, because at this moment in time it is not clear how long this period of uncertainty will last for and to what extent investors have been unsettled by it. One thing’s for sure: the longer the uncertainty surrounding the USA’s economic and foreign policy approach lasts and the more chopping and changing that goes on, the more reluctant investors will be.

 

Protectionism in the USA would weaken the entire global economy – and the USA, too

 

During the election campaign, Trump announced his intention to adopt a strict protectionist approach to external trade policy. Apart from pulling out from TPP, he also promised, among other things, to impose high tariffs on imports from China and Mexico and to renegotiate or even terminate existing trade agreements. While the implementation of measures targeting imports from Europe was not mentioned explicitly, the free trade agreement between the EU and the USA (TTIP) is similarly likely to break down in the immediate future.

 

It is therefore unclear whether and to what extent Europe will be affected by the trade restrictions that have been announced:

 

  • If the process of economic isolation targets Europe as well, this would lower European exports to the USA. Germany would be particularly affected by this: the USA was Germany’s most important export destination in 2015 with an export volume of approximately EUR 113.7 billion.
  • In the event the protectionist measures only affect booming emerging countries, exporting companies in Europe could even benefit from this in the short term: their products would gain a competitive edge over their counterparts from China and Mexico, which would lead to a rise in exports. In the medium and long term, however, Europe would also suffer as a result of the weaker growth in emerging countries, which would be linked to their bleaker outlook with regard to exports to the USA.

 

The objective of the American isolationist policy is to lower US imports by charging higher tariffs on them, and thus increase the demand for American products instead. In reality, though, this approach has little chance of succeeding (see Fig. 1):

 

  • An import tariff makes consumer goods imported from overseas more expensive for American consumers and thus diminishes the purchasing power of a given income.  The consumers have less money to spend on US products, meaning that the US economy will shrink due to the decline in the demand for goods.
  • The USA also imports pre-products that undergo further processing by US companies. An import tariff makes these pre-products more expensive and therefore increases production costs. This worsens the competitiveness of US companies internationally, and as a result their exports decrease. Furthermore, prices in the USA increase due to higher production costs, which further diminishes purchasing power and causes the US economy to shrink.
  • If the USA takes measures to restrict imports, it is highly likely that the trade partners affected by those measures will implement corresponding retaliatory measures. This would limit the USA’s export opportunities and weaken both American growth and employment.
  • If the USA limits the export opportunities of other countries by imposing an import tariff, this would weaken economic growth in the rest of the world. This means that the demand for goods in other countries would decrease, which in turn would cause the USA’s export opportunities to worsen and US growth to weaken.
  • In the long term, the productivity of the US economy would suffer from the policy of economic isolation: if there were a decline in the competitive pressure coming from companies overseas, this would lessen the need for American companies to make technological advancements in order to gain a competitive edge over their overseas competitors. For US consumers, this means that they would not benefit as strongly from technology-related price decreases and the associated purchasing power gains.

 

1

 

If the USA introduces protectionist measures, this would reduce growth, employment and productivity advancements in the USA as well. Perhaps these considerations will deter the world’s second-largest export nation (see Fig. 2) from actually implementing the isolationist course that was promised during the course of the election campaign.

 

2

 

Tax reductions and increased government spending in the USA

 

During the election campaign, Donald Trump announced massive tax reductions in combination with an increase in public investment. The exact scope of both measures is currently unknown but the amounts are likely to be in the three-digit billion, or even trillion, range. In the coming years this would result in a further increase in the USA’s public debt, which already stands at around 108 percent of American GDP at the moment.

 

A credit-financed investment program in the USA resulting in an increase in government debt would lead to various economic consequences for Europe:

 

  • In the short term, a credit-financed investment program would generate a rise in growth and employment in the USA. The associated income gains would lead to an increase in consumer demand among US consumers. This demand would apply to foreign products as well, meaning that European exports to the USA would increase. In order to carry out public investment running into the trillions, the USA would be dependent on further imports from Europe as well.
  • A construction boom in the USA would raise salaries and prices by increasing the demand for labor and consumer goods. This would lead to a higher inflation rate. Rising prices would reduce the competitiveness of the USA internationally. For Europe, this would mean improved competitiveness, meaning that European exports would increase – both to the USA and third countries.
  • A strong increase in US government debt would lead to a higher demand for credit. This tends to cause interest rates to rise in the USA. For example, the yields on ten-year US treasures rose from approximately 1.8 percent to 2.2 percent in the immediate aftermath of the US election. By the end of 2016, the yields stood at almost 2.6 percent. As a result, there is a greater incentive for international investors to invest their money in the USA. The associated higher demand for the US dollar leads to its appreciation, while simultaneously depreciating the euro. This depreciation makes European products cheaper in the USA, leading to a rise in European exports to the USA.
  • If international investors invest more money in the USA, this may lead to a withdrawal of capital from Europe. The European Central Bank would then be forced to raise the base interest rates in order to limit the effects of this withdrawal of capital. For those states in the Eurozone with particularly high debt, the resulting higher interest spending would lead to a further increase in government debt and intensify the European government debt crisis.

 

In the short term at least, Europe would therefore benefit from the American tax reductions and increased investment. In the medium and long term, however, the increasing government debt in the USA would lead to the following growth-dampening effects:

 

  • A rise in government debt would increase interest rates in the USA. This would have a negative influence on private investment and weaken US growth.
  • A rise in government debt would reduce the country’s credit rating and jack up the interest rates even further. Sooner or later the country would have to react, by restricting its spending and raising its taxes again. The latter would decrease the income available to consumers and reduce consumer demand. US companies would adjust their production to the declining demand for goods and simultaneously restrict their investments. The result would be a decline in production and employment, i.e. a recession. This would spread to the rest of the world, but the impact would not be as great as in the USA.

 

Conclusion

 

The uncertainty surrounding the new US government’s future economic policy is having a negative impact on the global investment climate. Were the USA to pursue a hardline protectionist course, this would have a further dampening effect on growth – especially in export-oriented countries like Germany. Yet it is unclear whether protectionist measures will actually be implemented on the scale announced, because this would weaken the US’ own economy. And even if the US does isolate itself, the growth-dampening effects this would have could – at least in the short term – be offset by the stronger US growth that would result from the targeted tax reductions and increased investment.

 

But in the medium and long term, the negative effects of the economic policy measures indicated during the election campaign threaten to prevail for Germany and Europe:

 

  • If the USA adopts a policy of economic isolation towards imports from emerging countries such as China and Mexico, this would weaken growth and employment in those countries. This sluggish growth would dampen the demand for imports in emerging countries, some of which are currently large import nations (see Fig. 3). And declining imports in emerging countries means declining exports for Germany and Europe, which, in turn, has a growth-dampening effect for Germany and Europe.
  • The rise in interest rates resulting from increased borrowing by the American state is likely to lead to a rise in interest rates worldwide. This would have a negative impact on investments and thus weaken growth.
  • Finally, it can be assumed that the credit-financed stimulus package would only work in the short term. In the medium term, necessary tax increases and reductions in government spending would weaken US growth. And an economic downturn in the largest national economy on the planet would then have a growth-dampening effect on the rest of the world too.

 

3

 

Germany and Europe should quickly prepare themselves for the growth declines that are looming in the medium term. The first step in this process is to strengthen the internal market. The associated intensification of economic integration means that Europe can generate additional growth momentum. A second instrument that could be used would be to intensify economic integration with other trade partners, particularly those in Asia and South America.