Economic Consequences of the US Election for Europe

The November 24 election of Donald Trump for a second term is likely to change the global economic framework noticeably from next year at the latest. The economic policy announced as part of his “America first” strategy poses considerable challenges for export-oriented European economies. Two measures are particularly relevant – higher tariffs on foreign products and corporate tax reductions. In the short term, these measures will likely strengthen US economic growth, but in the medium and long term, growth-dampening effects may predominate. Immediate negative economic consequences have to be expected for Germany and Europe.

Short-term consequences of US import tariffs for the US economy

One of Trump’s key announcements is the introduction of higher tariffs on foreign products. The aim is to increase competitiveness of American companies, therefore increasing production, employment and income in the US. If US consumers substitute foreign products, which will become more expensive, with domestic ones, this strategy will be successful.

But import tariffs are associated with negative side effects for the US economy. They not only make foreign products more expensive, but cause general price increases. This is because US products are more expensive than the originally imported goods. As a result, US consumers have to pay higher prices, leading to a collective loss of purchasing power via disposable income.

These losses could be compensated by an increase in nominal wages. The prerequisite is a higher demand for labour in the US, which could actually happen. There are two reasons for a higher labour demand. The first is increased production by companies already based in the US. Secondly, if European companies fear losing US sales because of higher tariffs, they may choose an alternative strategy.

This would consist of constructing US production facilities in the US. In other words, European companies invest in production capacities in the US to bypass US import tariffs. As a result, additional jobs are created in the US. With sufficiently strong nominal wage increases, real wages might rise, which would boost US consumption. Consequently, production and income in the US economy could supposedly keep growing.

Short-term consequences of US corporate tax cuts for the US economy

Planned corporate tax cuts will make foreign investment in the US even more attractive. Hence, the US can expect a further inflow of capital in the form of foreign direct investment.

These investments, such as purchasing existing production facilities or building new factories, must ultimately be paid for in the US currency. The resulting increase in demand for dollars leads to an appreciation of the dollar. A stronger dollar is likely to weaken the price competitiveness of American companies because their products will become more expensive in the rest of the world.

Public debt is already high in the US and it is likely to rise further because of tax cuts, even if US economy grows and import tariffs generate higher revenues. The consequence of rising public borrowing is a rising interest rate for US bonds, leading to a general rise in US interest rates. This will increase demand for US government bonds, including from foreign investors. As these bonds must be paid for in dollars, demand for US dollars continues to rise and appreciates even further.

Tax breaks increase investment by US companies in their own country. If more production facilities are built and machinery required, this boosts US production of capital goods. If this leads to rising employment, further nominal wage increases should follow. As a result, the demand for consumer goods in the US increases, with companies responding by boosting production.

In addition, investments often increase productivity because they are usually linked to more modern technologies. This strengthens the international competitiveness of the US economy.

In the first few years of the 47th US Presidency, import tariffs and tax cuts could have positive effects on the US economy. However, the longer they are in place, the more likely they are to have a negative impact.

Growth-dampening effects of the announced policies for the US economy

Rising demand for investment and consumer goods has an inflation-increasing effect. In the short term, this can be kept in check in two ways. Firstly, US companies may increase their output and dampen inflationary pressure by increasing the supply of goods. Secondly, an appreciating US dollar makes imported products cheaper for American consumers, also dampening inflation.

But sooner or later, a permanent increase in demand for capital and consumer goods in the US will come up against aggregate production capacities that can no longer meet this demand fast enough. And when excess demand arises, prices and inflation will go up in the US.

This results in a loss of purchasing power, causing real wages in the US to fall. If they are offset by correspondingly high nominal wage increases, production costs increase. This means higher import tariffs become necessary to keep US companies price-competitive – and that would accelerate price rises in the US.

To combat inflation, the US Federal Reserve will likely raise its interest rate. In addition, interest rates will rise if US public debt continues to increase. Higher interest rates usually have a negative impact on companies’ investment activities.

In all likelihood, this will bring the post-election US economic boom to an end. High inflation rates worsen the international competitiveness of US companies and rising interest rates reduce demand for capital goods. As a result, production, employment and income in the US will fall.

Past US experiences with protectionist measures demonstrated that import tariffs had a negative impact on overall economic development in the medium and long term. Selected examples can be seen in Figure 1.

Consequences of US economic policy for Europe

Higher US tariffs may not be imposed immediately on all imported products. However, Chinese and European goods are likely to be affected first by Trump’s tariff policy.

In this scenario, China’s export opportunities to the US would decline. Therefore, China would have to look for other sales markets. Against the backdrop of a weak Chinese economy, selling these products in the domestic market will probably not prove to be an effective strategy. Instead, China would most likely try to sell the goods manufactured with the existing production overcapacity in Europe, possibly with the support of public subsidies.

This puts European companies under pressure in several ways. First, sales opportunities in the US will decline. Second, increasing import pressure from China puts additional pressure on European companies. And third, it is likely to become more difficult for European companies to sell their products in China.

The global economy is at risk of a protectionist race. China is likely to respond immediately to US import tariffs and impose tariffs on US products – as it did during Trump’s first term in office – but there is a high probability that the EU will respond to US tariffs on its own products.

Another growth-dampening effect results from withdrawing capital from Europe. If capital is removed from Europe in favour of a more attractive investment climate in the US, investment in Europe declines and long-term economic growth is weakened (see figure 2).

Finally, the depreciation of the euro, which is the mirror image of a dollar appreciation, must be taken into account. A weaker euro has advantages and disadvantages.

• A weaker euro makes imported products more expensive. This increases the price of imported raw materials – especially fossil fuels such as oil and gas – as well as intermediates and final products. This will lead to increased inflation and declining export opportunities for European companies. In addition, a loss of purchasing power weakens domestic demand for consumer goods.
• The advantage of a weaker euro is improved export opportunities for European companies. However, if the US makes market access more difficult with import tariffs and other countries take protectionist measures, this advantage would remain largely ineffective.

What can the EU do next?

The new US government’s expected economic policy implies a considerable burden for the rest of the world. To counteract the threat of weakening European economies, the EU can take action in these two main areas:

1. Intensified trade and economic relations with other economies: Free trade agreements with countries in the Indo-Pacific region, India and the EU’s neighbouring countries open up improved sales opportunities for exporting companies in the EU and their suppliers.
2. Stronger domestic demand: To achieve the ecological transformation required by 2050, the EU will need high levels of domestic private and public investment over the next two decades. From this perspective, a falling demand for export goods is a prerequisite for a significant increase in climate-protecting investments in Europe. Such investments are primarily a task for private companies. But in addition to essential public investment, the state should support companies and private households with tax relief and financial aid. This requires correspondingly high levels of public funding.

Regardless of what measures European economic policymakers choose, a quick, courageous response to the expected US economic policy is vital. Without such a response, Europe will risk production, employment and income losses. The result would be social tensions that would further weaken already strained social cohesion across the bloc.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specialising in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises, as well as the chances and risks of globalisation. Most recently, he worked on the effects of carbon pricing and the benefits of a potential global climate club.

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