Weakened Europe fears Trump and China will divide and conquer on trade

(Originally published Dec. 17 in “What in the World“) Germany’s Chancellor Olaf Scholz on Monday lost a confidence vote in parliament.

The loss, which was expected following a split between Scholz’ Social Democrats and its coalition partner the Free Democratic Party, means fresh elections for Germany in late-February that plunge Europe’s largest economy into the same political and economic limbo as France—just as Europe faces the likelihood of new tariffs following the January inauguration of U.S. President Donald Trump. Germany’s Bundesbank last week said the German economy would likely grow just 0.1% next year.

(Outgoing) Economy Minister Robert Habeck perhaps predictably laid much of the blame on the government of former Chancellor Angela Merkel, saying she had erred in trusting Germany’s energy security to Russian President Vladimir Putin, in relying so heavily on exports for economic growth (Germany is still the third-largest exporter behind China and the U.S.), and in so doing misreading what was happening in China, the likelihood of a Trump presidency, and an unwinding of globalization.

Credit-rating agency Moody’s, meanwhile, over the weekend downgraded its rating on France’s government debt, to Aa3 from Aa2. Moody’s cited a “very low probability that the next government will sustainably reduce the size of fiscal deficits beyond next year.” On the contrary, the agency said France was at risk of developing “a negative feedback loop between higher deficits, a higher debt load and higher financing costs.”

European Central Bank President Christine Lagarde said Monday that the bank was likely to cut interest rates further as “the darkest days of winter look to be behind us.” By winter, Lagarde apparently meant inflation. Given the prospects for lower growth, weaker government spending, and political turmoil, Europe appears to face much darker days ahead. The ECB last week cut its benchmark interest rate for the fourth time this year, to 3% from 3.25%, and markets expect it to halve that rate before it’s done.

Trump has threatened blanket tariffs on imports and has complained that Europe imposes higher tariffs on U.S. goods that vice versa. In addition to retaliating with higher tariffs on imported European cars and food, European Union officials also worry that Trump’s threatened tariffs on China will result in Chinese companies dumping goods in Europe to compensate for lost revenue.

The real worry is that, when the trade war begins, Europe’s individual nations will break ranks and negotiate deals of their own with both Beijing and Washington. Trump is reportedly likely to favor negotiating with individual European nations rather than with Brussels; and individual countries aren’t likely to support Europe-wide tariffs to protect a neighbor from cheap Chinese imports if it means China retaliates against their own exports.

But lower rates and a weaker Euro will could help offset some of the economic weakness, Natixis economist Alicia Garcia Herrero points out in her newsletter “EuroAsia and the World:”

A weaker euro would be good news given the depressed economic situation in France and Germany, and the positive impact it would have on the external competitiveness of the eurozone. That’s especially true as Trump’s tariffs will also likely target the European Union, though to what degree is highly uncertain.