The Risks of American Protectionism for Europe

Philipp Liesenhoff

German Council on Foreign Relations

Philipp Liesenhoff is an Associate Fellow with the Globalization and World Economy Program of the German Council on Foreign Relations (DGAP) in Berlin, where he works on Germany’s economic and foreign policy, Eurozone integration, and transatlantic economic relations. An economist by training, he worked as a research assistant at the German Marshall Fund between 2014 and 2017 and has previous work experience at the German Federal Ministry of Finance, the Federation of German Industries, and the German Institute for International and Security Affairs (SWP). He is an AICGS/GMF Fellow with the American-German Situation Room.

He holds a master’s degree in International Economics from the University of Bayreuth and received his bachelor’s degree in Governance and Public Policy from the University of Passau. He is completing his PhD in economics and was a visiting scholar at the School of Advanced International Affairs (SAIS) at Johns Hopkins University in Washington, DC, in 2016/17.

He is a 2018-2019 participant in AICGS’ project “A German-American Dialogue of the Next Generation: Global Responsibility, Joint Engagement,” sponsored by the Transatlantik-Programm der Bundesrepublik Deutschland aus Mitteln des European Recovery Program (ERP) des Bundesministeriums für Wirtschaft und Energie (BMWi).

The Trump administration’s May 1 deadline to decide on tariffs for the European Union has been extended, and uncertainties remain. Published in March in German, this article offers policy prescriptions for the EU given a protectionist U.S., a competitive China, and a damaged WTO.

The decision by U.S. president Donald Trump to impose steel and aluminum tariffs poses great risks for Europe and the global trade system. The temporary exemption for European countries until May 1 only provides short-term relief. Specifically, European companies are likely to suffer sales losses as a result of the new U.S. tariffs because overcapacities from other countries like China will divert to Europe. The greatest danger, however, lies in that the global trade order and the World Trade Organization (WTO) could be damaged or even break. In the case of an escalating trade war, the EU would also feel considerable macroeconomic consequences in prices, growth, and financial stability.

The European Union (EU) should be united and decidedly opposed to the protectionism of Donald Trump. Should the U.S. at a later point also impose steel and aluminum tariffs on imports from Europe, the EU should bring a case against the U.S. at the WTO and introduce countermeasures. If this escalates, the EU should also be prepared to exploit other policies to reach a compromise, similar to what has already been done in tax policy. In the event of a global trade conflict, in which China will also be entangled, it should ensure its own economic resilience through the necessary reforms of the Eurozone.

U.S. Tariffs as Guarantee of National Security

As of March 23, 2018, the U.S. has imposed tariffs of 25 percent on steel and 10 percent on aluminum. These are the highest tariffs in any product category since 1971. This decision by President Trump is based on a study from the U.S. Department of Commerce on the importance of the domestic steel and aluminum industry for the national security of the U.S., which the president commissioned by executive order. Commerce secretary Wilbur Ross identified action for the protection of these industries under Article 232 of the Trade Expansion Act from 1962, and gave the White House a comprehensive report that includes recommended actions.

In this report, the department proposed two additional trade-policy measures: a tariff of 50 percent on steel imports from twelve countries, which according to this analysis contribute to market and price distortion, including Russia and China, or the implementation of an import quota for steel and aluminum in the range of 63 percent of the previous year’s level. To the horror of his transatlantic and North American partners, President Trump chose the maximum variant: a non-discriminatory tariff that, according to the president, will last for a long time.

The U.S. government justified these tariffs with Article 232 of the 1962 Trade Expansion Act, which allows restrictions and import bans should the national security of the U.S. be endangered. According to this provision, the president has almost sole competence to decide on the amount and duration of such tariffs. International trade law in Article 21 of the General Agreement on Tariffs and Trade (GATT) also stipulates that every state may restrict imports, should these endanger national security. Predecessor governments, however, have always narrowly interpreted this provision and limited it to the production of nuclear capabilities, weapons, and military equipment in times of war and emergency. They also emphasized a transparent investigation. In addition, distinct proof had to be provided that domestic production of security-related products was inadequate, and that the U.S. military depended on imports from countries that the U.S. does not consider close allies. President Trump broke away from that. He justified the protection of domestic producers with the view that even steel imports from closely allied states, such as Canada and the EU, endanger American security.

The Damage for Transatlantic Trade

For several years, there has been enormous price pressure on steel and aluminum in the world market. Through massive state subsidies, China has created global overcapacity for steel and aluminum, which puts the market price for these goods lower than the cost of production for many Western firms. China is still one of the top exporters of aluminum to the United States; Trump’s tariffs of “only” 10 percent will hurt Chinese manufacturers. By contrast, steel imports from China have significantly dropped the last few years in the United States, not least because of the tariffs of over 500 percent that President Obama had already introduced on certain Chinese steel products. Since then, China ranks only eleventh in terms of steel exports to the United States.

Other countries—including the EU—filled in these gaps. Germany has increased its steel exports to the United States by about 40 percent since 2011, and with that moved up to the eighth largest exporter of steel to the United States. In total the EU has exported $6.2 billion worth of steel to the United States in recent years. If Trump does not exempt Europe from the tariffs, the number of exports from Europe could be cut in half. Either way, a flood of goods from not only China, but also Russia, threatens the European market.

The direct economic damage is not the only thing that makes the Trump administration’s decisions so problematic for the EU. The four largest exporters of steel to the U.S. are Canada, Mexico, South Korea, and Brazil. While South Korea and Brazil have threatened to take retaliatory measures, the U.S. administration has halted the tariffs for thirty days for Canada and Mexico. The latest round of negotiations of the North American Free Trade Agreement (NAFTA) falls during this period. The renegotiation of NAFTA (which has bound the U.S., Mexico, and Canada for twenty-four years) has stalled over the controversial rules of origin of automobile imports into the United States.

Currently, 62.5 percent of imported automobiles has to be produced in the NAFTA region in order to be exempted from tariffs. However, U.S. Trade Representative Robert Lighthizer is calling for this floor to increase from 62.5 to 85 percent and is requiring a higher share of American content. If Mexico and Canada embrace this change to the rules, they would be permanently exempt from the U.S. tariffs on steel and aluminum. But for European firms, the stricter rules of origin could mean loss of production and raised adjustment costs. There are 5,800 active German companies in NAFTA that have access to half the world automobile market via free trade agreements with Mexico and Canada.

The Special Case of China

China could also come under pressure as a result of U.S. tariffs if it is forced to compensate for the expected decline in domestic demand with higher exports in order to reach its official growth target of 6.2 percent. Given the high level of debt of Chinese firms and local governments and the uncontrolled lending in their shadow banking system, the country must implement extensive structural reforms. But such reforms will weaken domestic demand, and so China is more dependent than ever on exports and a competitive currency. Should the trade conflict with the U.S. escalate and exports shrink further, the Chinese administration could initiate trade and economic policy countermeasures that would mark a departure from its previous strategic equanimity.

The U.S. declared recently in its national security strategy that China is a strategic competitor, which undermines the prosperity and security of the United States through unfair practices. Before the tariffs on steel and aluminum, the U.S. had already raised tariffs on solar panels and washing machines. Now the U.S. has imposed the most massive trade restrictions on China following a U.S. Department of Commerce investigation into intellectual property rights (IPR) infringements under Article 301 of the 1974 Trade Act. The damage to China’s economy and the domestic reputation of President Xi could be immense: with tariffs on Chinese high-tech goods, investment restrictions, and visa limitations for Chinese citizens, the U.S. wants to cut the trade deficit with China by $100 billion. China’s government has already announced retaliation in the form of tariffs on goods, including industrial and agricultural products, worth $3 million. In the case of trade diversion of Chinese products, the European market could then also become flooded with Chinese products. Thus, negative consequences for the EU and a further shift of the protectionist spiral are foreseeable.

Macroeconomic Risks for Europe

Macroeconomic implications of American protectionism can be expected. If more countries answer the United States’ levying of tariffs with counter tariffs so that a spiral of trade barriers arises, this would lead to a global trade war. In such a case with comprehensive mutual tariffs of 10 percent, the OECD forecasts a 6 percent reduction in the volume of global trade and a 2 percent decline of real GDP for China, the EU, and the U.S.

However, these forecasts do not consider the full effects of temporary disruptions of global supply chains—through which the cost of production and prices resulting from the implementation of tariffs could increase exponentially—of global political escalation, or the resulting market uncertainty.

Should it come to a trade war, inflation in the U.S., contrary to current predictions on global financial markets, would sharply increase due to American dependence on imports. The Federal Reserve, under new leadership from Jerome Powell, would have to raise interest rates much faster and more severely. Because the Fed is the driving force globally for financial cycles, the pressure on the European Central Bank (ECB) would increase to raise their interest rates faster as well. The general political uncertainty that originates from Donald Trump’s politics, worldwide fear of a trade war, and the rising public debt of the United States could also ensure the exchange rate of the dollar remains low for a while. This could result in a loss of competitiveness for the EU and threaten European exports since the U.S. is the most important trading partner and export market for the EU. As a result, the ECB would be in a predicament because with its loose monetary policy, the ECB continues to make a substantial contribution to the economic recovery and stability of the Eurozone. So far, the euro states have not managed to achieve the comprehensive institutional reforms that could secure European financial stability, such as the permanent decoupling of sovereigns and the banking sector.

Conversely, the Fed could overreact in response to the high chance of inflation and could initiate a financial slump through an excessive increase of interest rates. A recession in the U.S. during Trump’s tenure seems not just possible, but likely. An economic crisis in the United States, whose public debt will rise due to the tax reform and therefore has less financial leeway as a cushion for falling demand, would present a huge problem for the global economy and the export-oriented European economy.

The Fed and the ECB must find strategies to exit the ultra-loose monetary policies that have persisted since the global financial crisis. In the case of an escalating trade conflict, the delicate balance that the ECB must find could be undermined. With uncertainty, long-absent volatility has also returned to financial markets, obliging regulators, politicians, and central banks to focus more on the stability of markets and individual financial institutions. American policies and deregulation measures, such as the weakening of the Frank-Dodd Act of 2010, could potentially intensify a recession. These shocks could be transferred onto European markets due to the high levels of integration of transatlantic financial markets.

Eventually, China will also come under pressure to ease its macroeconomic policies in the face of American trade pressure. But the country cannot easily devalue the yuan, because it is facing the dilemma of having to strengthen its export economy while at the same time wanting to keep their currency stable against at least a few other currencies. The Chinese government fears that capital outflows, which it recently managed to curb via capital controls, would be revived by classic devaluation of the yuan.  Additionally, as part of a six-month currency report by the U.S. Treasury, the U.S. government is directing special attention to the exchange rate between the dollar and the yuan and is eying sanctions against China in there is currency manipulation. The threat of selling U.S. Treasury bonds, of which China owns many as the largest creditor to the United States, is not very serious due to China’s great dependence on these reserves, which would thereby be devalued.

For these reasons, Chinese leadership will avoid using monetary policy as a trade policy weapon and will want to solve its monetary problem quietly and more subtly. The extent to which Europe can already be affected by such a subtle currency adjustment mechanism is evidenced by the decision of the Chinese central bank to suspend an anti-cyclical stabilization instrument, which has generally adjusted the yuan upward. China’s export economy experienced the impacts of appreciation against the dollar only marginally, as it was offset by a simultaneous devaluation against the Japanese yen and the euro. Under the enormous pressure of trade loss through massive punitive tariffs under Article 301, the administration in Beijing could be tempted to devalue the yuan even more against the euro to strengthen their export economy against a (further) major economic competitor should this not be possible against the dollar for economic and political reasons. The accumulation of euro reserves of the Chinese Central Bank would push up the already-strong euro and make European exporters less competitive.

Implications for the Global Multilateral Trading System

The American tariffs threaten the world trading system and the WTO, which are based on the idea that conflicts over national measures are carried out before a dispute settlement system with regulated possibilities for countermeasures. If the question of whether the tariffs on steel and aluminum are essential to the national security of the United States were brought before the WTO, whatever way the judges decide would pose immense risks. For example, a finding against the U.S. tariffs with the goal of a formal clarification from the WTO could permanently paralyze the institution and break the liberal trading system.

On the other hand, should China, for example, bring an action against the U.S. tariffs at the WTO and win it, the United States would be obligated to lift the tariffs because of its WTO membership. For the U.S. this would mean being denied measures to protect U.S. national security. There is a great risk that in such a situation, Donald Trump, with support from his voting base and more conservative Republicans, would terminate the United States’ membership in the World Trade Organization. If the largest national economy leaves the WTO, the existence of the organization would be endangered and the future of international trade unpredictable.

If, however, the U.S. were to bring an action before the WTO and win, the trade organization would have created an extremely risky precedent that would legitimize its protectionist application to other states as well. This could lead to a global downward spiral, which could result in trade wars. The alternative to both of these options of a WTO procedure is that each country is aware of the “lose-lose” situation of a formal complaint and no country lodges a complaint.

Outlook for Europe

The EU is temporarily exempted from the steel and aluminum tariffs, but this is only put forward as a bargaining chip by the Trump administration against the EU. The European Union has until recently threatened a list of countermeasures in the case of U.S. tariffs actually being implemented. Europe is well advised to keep these options on the table and to assert its interests vis-à-vis the United States. A quick and hard reaction of the EU will be possible at any time given the fact that the European Commission is well prepared. A reaction would also be necessary in order to stay credible from a trade-policy point of view. This includes a case  against the American punitive tariffs at the WTO, counter-tariffs on steel and aluminum for protection against a glut in the market, and retaliatory measures of €5.5 billion implemented in stages over time. In addition, tariffs on Bourbon whiskey, blue jeans, Harley Davidson, as well as a list of agricultural products, are included that will impact the voter base of President Trump and leading Republicans.

The U.S. administration recently laid out five criteria for granting an exemption: first, the respective country must cap its steel and aluminum exports to the U.S. at the level from 2017. Second, it must implement countermeasures against China’s market-distorting practices. Third, the country should be more cooperative with the U.S. and more confrontational towards China at the G20 Global Steel Forum. Fourth, the U.S. requests increased cooperation regarding WTO cases against China. Fifth, the country should expand its cooperation in defense policy with the U.S. To what extent these conditions must be filled remains unclear.

But even considering these criteria the EU should be clear that it will probably not receive a lasting exemption from the tariffs without accommodating the U.S. on a larger field. While many observers point out that the real target of the steel and aluminum tariffs is China, the fact that there already are massive U.S. tariffs on Chinese steel suggests that the EU was not accidentally targeted by Donald Trump. The White House wants the Europeans to meet the 2 percent of GDP spending target for NATO defense and a reduction of the U.S. trade deficit. The latter also includes Trump’s request for an adjustment of European tariff on automobiles which at 10 percent is much higher than in the U.S. (2.5 percent).

President Trump reiterated his criticism of the bilateral European and German trade surplus with the U.S. and wrongly blamed trade policies. One year ago, he suggested an import tariff of 35 percent on cars from Europe that, however, was not implemented. The U.S. is the most important market for auto exports from the EU. German manufacturers, who in 2017 sold 1.35 million new vehicles in the U.S., would be particularly impacted by automobile tariffs. Depending on what production adjustments are undertaken by European manufacturers, these tariffs could cause a decrease in exports in the U.S. of a half million automobiles and economic damage in Europe worth between €5 and €17 billion.

The escalation to a trade war seems possible. President Trump and his hardliner team, made up of Secretary of State Mike Pompeo, trade advisor Peter Navarro, Secretary of Commerce Ross, Trade Representative Lighthizer, and National Security Advisor John Bolton, will try to reduce the economically irrelevant bilateral trade deficits with China, the EU, and other nations. With the Trump administration’s “America First” ideology, the U.S. under this presidency turns out to be exactly what Europe feared from the rise of China: a self-righteous power with a disregard for international rules and without regard for casualties in its quest for self-enrichment.

A European Strategy toward the U.S.

Even if it does not come to a complete escalation due to imposed aluminum and steel tariffs, the situation is exemplary of the new transatlantic normality.

The danger of a trade war in transatlantic economic relations will probably remain during the entire governing term of Donald Trump. Europeans must adjust to constant political conflicts with Washington. If the U.S. continues to use trade policy as a power-political instrument, other nations may increasingly follow this example, either to avert a trade war or to respond appropriately to trade policies of other countries. This is why the EU needs a tactical answer to U.S. policies that takes this danger into account. In addition to safeguarding its interests through trade and economic policy countermeasures, it must also be able to implement trade-offs between policy areas (for example, compromise on fiscal policy against trade concessions), but without questioning the primacy of multilateralism.

The European response to the U.S. tax reform could serve as a model, as stated in a letter from the finance ministers of Germany, Italy, France, Spain, Great Britain, and the two responsible EU commissioners to this year’s Argentine G20 presidency prior to the Minister of Finance Summit in Buenos Aires on 19 March. The authors suggest a revision of the taxation of digital companies like Facebook and Google on a global scale to internationally regulate tax evasion and tax dumping. At the same time, the EU presented its own draft for an equalization tax on digital services, which largely imposes higher taxes on American companies. A compromise with the U.S. on this issue could be linked to an agreement on trade policy or the controversial “Base Erosion and Anti-Abuse Tax” (BEAT) paragraphs of the U.S. tax reform, which in effect means double taxation for European financial services providers. This not only requires a certain preparation for escalation on the part of the EU, but also calls for increased diplomatic efforts toward Washington to prepare for possible compromises in multilateral fora and to encourage the U.S. to participate in multilateral formats. In the current transatlantic ice age, the relationship between political leaders of both blocks is particularly important for a constructive transatlantic relationship.

Strategic Partnerships of the EU

If the U.S. continues to weaken multilateral agreements or even pulls itself completely out of the WTO, the EU would face a difficult decision: Should it engage in pseudo-alternatives to the transatlantic economic partnership within the WTO as it presented to China in Davos with a commitment to rules-based free trade? Ultimately, these commitments are driven by China’s desire to maintain its market economy status within the WTO, while its geopolitical and geo-economic measures such as the Belt Road Initiative (BRI), “Made in China 2025,” and the continued closing off of its domestic markets have counteracted free trade and multilateralism. Unlike some European company bosses, who already see the BRI as a new WTO, the European Union should realize that it will have to make do without (alternative) strategic partnerships for the foreseeable future. It is true that it maintains close economic ties with important partners such as Canada, Japan, Mexico, and MERCOSUR, and also shares with them the vision of a rules-based multilateral system. The American market and the geopolitical role of the U.S., however, remain too important for Europe to not take them into account when designing the future economic system. Paradoxically, the EU and its members could use the otherwise inefficient muddling-through practice, which describes the tactical and pragmatic coordination of different policy stances and content of euro states during the sovereign debt crisis, in the preservation of interests in the transatlantic commitment dilemma.

Inner-European Reforms

Given the possible consequences of U.S. trade policy for the world economy and the EU, reforms—especially in the Eurozone—reforms are becoming more important. To ensure its economic resilience and stability, the Eurozone must first of all solve the problem of the so-called “bank-sovereign doom loop.” In addition, a limit on the number of government bonds banks of the same country may hold should be imposed. The completion of the banking union through a joint deposit guarantee is also needed. In addition to focusing on long-term debt reduction, monitored by independent European supervision, there must be risk-sharing mechanisms for a potential renewed crisis that guarantee effective, transparent, and automatic capital allocations for the stabilization of the Eurozone. This ultimately cannot be achieved without a secure common bond, such as synthetic European Safe Bonds (ESBs), and a fiscal backstop, which lends states capital in difficult times under clear terms. This topic has been controversially discussed for years among the member states. The positive domestic economic outlook for Europe combined with the growing external threat to European economies could now contribute to a constructive political momentum for economic and institutional reforms in the EU.

At the same time, countries like Germany, whose political resistance to these reforms led to repeated delays, should be aware that their export surplus model significantly contributes to the worsening problem of global trade imbalances, and because of external threats to European free trade—such as those posed by the Trump administration—is dependent on other member states. Their economic concerns were not always taken seriously in the past.

Transatlantic Dissent with a Future

Under the influence of a national wave of anti-globalization, the U.S. under President Trump is transforming itself from the global leading power of the twentieth century to an illiberal self-enriching power. The Trump administration not only undermines the international consensus for trade policy, but is also basically bidding goodbye to the commitment to consensus-oriented solutions among allies. The European Union has long struggled to find a political answer to the constant and unpredictable threats from Donald Trump. With its first serious measures in the trade dispute about steel tariffs, it has now put itself in position. From now on, the active and pragmatic defense of its economic interests will need to be the highest priority for the EU. Not only does it have to manage the new normality of the transatlantic relationship, but also face China with open eyes. The EU member states should increase the pace of institutional and economic reforms to increase its resilience and external independence. As bad as the transatlantic relationship already is, it could still get worse.

Translated from German by Mikayla Appell and Taylor Nelson.

The views expressed are those of the author(s) alone. They do not necessarily reflect the views of the American-German Institute.