24 June 2018

Even in comparison with the recent deterioration in diplomatic norms, the breakdown of the recent Group of 7 meeting was breath-taking.  The long-planned gathering, cut short by US President Trump’s early departure for his hastily planned Singapore summit with North Korea, began with Donald Trump’s advocacy to include Russia in future occasions.  The gathering hit its nadir (or one would have thought) as the leaders of nation’s closest allies surrounded the American President angrily attempting to persuade him to sign the joint communique (see the now infamous photo above).  He refused. And, just when one thought it could not get any worse, the weekend ended with Canadian Prime Minister Justin Trudeau publicly criticising the US decision to use national security justifications to impose steel and aluminium tariffs on its allies.  The US President shot back via Twitter that his Canadian host was “weak and dishonest”. American Trade negotiator Peter Navarro added that “a special place in hell” awaited Mr. Trudeau!  As they say, “with friends like this…….”!!

Meanwhile, the US President continued his critique of America’s key trading partners’ unfair, non-reciprocal trading practices.  On this occasion the European Union came under particular scrutiny.  Mr. Trump has threatened tariffs of as much as 25% unless European leaders take action to reduce the expanding bilateral trade imbalance. In the past, I have suggested that despite tough talk, China and the USA should be able to avert a trade war, largely as there is so much China can/should/will do to satisfy American concerns.  Arguably, the situation with Europe is trickier. As European leaders do not believe their trade practices are the cause of the bilateral imbalance, they are likely to push back — hard — on threatening American tactics and actions.  Again, while I expect common sense and shared interests to prevail eventually, tensions will  assuredly escalate in the period ahead.

What’s At Stake: Let’s All Take a Deep Breath

Before launching a trade war, let’s all pause for a deep breath to consider what’s at stake. While China’s potential rightly grabs the headlines, Europe remains American’s largest trading partner with total sales of goods and services exceeding $1.2 trillion (6% of US GDP). Europe is the top destination for US goods exports, representing 18% of overall sales abroad, and ranks second on goods imports (behind China).

Importantly, Europe dominates also the key service sector trade — especially crucial as US service exports  abroad have grown at twice the pace of goods sales since 2000. Europe represents 30% of foreign purchases of these services, more than Canada, Mexico, Brazil, China, India, and Japan combined. The United Kingdom is America’s largest single partner.

Bilateral direct investment ties also run deep. US foreign direct investment totals $5.3 trillion (over 25% of GDP), having doubled in just the past decade and up 4-fold since 2000. Europe has benefited from 60% of these American external investments ($3.3 trillion).  Again, the United Kingdom is the top beneficiary world-wide ($602 billion), and eight European nations are amongst the top 15 US investment destinations.  On the other hand, European direct investment into the USA exceeds $2.6 trillion, and represents 70% of the overall $3.7 trillion of direct investment inflows into the USA.

As a result, sales by US multi-national corporations (MNCs) operating in Europe exceed $3 trillion (15% of US GDP). Meanwhile, European MNCs enjoyed sales of $2.3 trillion in the USA.  European leaders are quick to observe that the balance of sales of MNCs favours the USA by over $700 billion.  Consequently, US products actually have an overall trade surplus with Europe if both bilateral trade and MNCs’ activities are combined!!

As the trade debate often centres on jobs, it is worth noting that over 4 million Americans work at European MNCs operating in the USA (3% of total US employment), and 800,000 new jobs have been added since 2009.  Would President Trump want to risk those jobs? Meanwhile, US MNCs operating in th EU employ more than 4.5 million Europeans.

Clearly, the depth and importance of the relationship runs in both directions. The Chart above indicates that the USA is the top destination for European exports (after omitting intra-EU trade), representing 20% of sales abroad. The four European G7 members’ reliance on the US market is even higher than the average (as is Ireland at 55%!).

Despite  the importance of this bilateral relationship, however, it is not difficult to observe why Europe is now a target of US trade vigilantes.  The top Chart illustrates the sharp rise in America’s trade deficit with Europe in recent years (from $96bn to $151bn between 2008 and 2017, although the 2017 gap is reduced to $101bn when the trade in services is included). During this interval, overall US exports rose 20%. In contrast, sales to Europe advanced only 4%, and exports to Germany actually declined. At the same time, Europe increased its penetration into the US market: overall US imports rose 11%, while purchases of European goods expanded 18%. And, while the 25% gain in US service sector exports to Europe is better, the share of American services consumed by Europeans has declined from 36% to 30% during the period.

What is NOT to Blame!

Fortunately, the deterioration in the bilateral imbalance appears to have peaked in 2015. However, this will not appease the Trump Administration trade hawks.  Before considering what’s responsible for the gap, let’s rule a few things out.

First of all, currency manipulation is not to blame.  The Chart illustrates that the US dollar is in line with its long-term average.  And, the USD actually has been undervalued during most of the post-crisis period during which the bilateral trade gap widened. (The same conclusion would be reached looking at the trade-weighted Euro).

Likewise despite the Trump Administration’s persistent focus on an unfair, multilateral trade regime, tariffs do not play a meaningful role in America’s imbalance with Europe.  The Chart illustrates that tariffs imposed on imports by both countries are low and similar. Levies on non-agricultural products average a mere 3% and 2% for the EU and USA respectively. Sectoral differences exist, and much focus is placed on the gap on automobiles: 3% and 10% for the US and EU respectively. However, does anyone really believe this differential is decisive in the decision to purchase German cars. The confidence of German automakers is revealed by their offer to eliminate tariffs in this sector in exchange for improved access to the US SUV market.

Both countries protect their agricultural sectors. To be sure,  European agricultural  levies exceed those of the USA, and are especially high in certain sectors such as dairy. With an eye on Wisconsin voters, Trump’s focus on this sector is cynical, but unsurprising.  In truth, potential trade gains in the agricultural sector appear limited.

Macro-Imbalances Explain the Deficit

As I have described in earlier blogs, America’s world-wide trade deficit reflects its low level of savings compared to its trading partners.  The same is true in the US-EU bilateral relationship: to reduce the gap the US must save more, and Europe must spend more. The following  Chart illustrates the US export/import ratio overall and compared to key trading partners.  As a deficit nation, the US overall ratio is well below 100.  But, the metric with the EU is roughly in line with America’s average world-wide,  suggesting  there is nothing in Europe’s specific trading regime to explain the bilateral gap.  The bilateral imbalance reflects a “spending gap”, not discriminatory trade practices.

The following Chart highlights how this factor contributed to the widening of the bilateral trade gap since the Financial Crisis. To be sure,  America’s post-crisis recovery has been tepid.  However, US domestic spending growth has signficantly outpaced Europe’s, as Euroland had to cope with the Euro Crisis and the ensuing fiscal austerity. Also, observe the bilateral trade gap peaked in 2015, just as European GDP and spending growth accelerated.

What to expect in the period ahead? The American savings rate is likely to fall not rise, as the recent tax reform balloons the US budget deficit. On the other hand, Europe’s large budget deficits, high debt levels, and already negative interest rates limit the scope for policy stimulus. The key to higher European incomes and spending lies in measures to boost productivity and deregulation, especially in its vast, under-developed, and over-regulated service sector. This will take time.

The Chart above indicates Europe’s import of US services could be much higher, e.g. compare Canada’s performance in particular. The potential for expanded American service exports appears especially large in Germany, Italy, and France.

The performance of individual EU nations is also revealing. First of all, the US runs a deficit with 22 of the 28 EU members, revealing the macro nature of the problem.  However, Germany and Italy account for over 60% of America’s deficit with the EU.  Germany, rightly, will attract criticism for its bloated current account surplus.  Germany must do much more to boost spending: fiscal expansion and service sector deregulation.  Italy must boost productivity in order to raise incomes and spending.

Strategic Implications

• The US-EU trade imbalance reflects differing patterns of spending in the two areas, not particularly discriminatory trade practices.
• The US must lift its savings rate to curb its global deficit and the shortfall with Europe.  However, expansive American fiscal policy is lowering US savings further.  As a result, after declining since 2015, the bilateral deficit with Europe has widened 20% in 2018. Likewise, America’s global trade deficit has widened 10% so far this year.
• American negotiators should focus their efforts on pressuring Europe to boost incomes and spending. With limited scope to expand macro-policies, this will require efforts to boost productivity and deregulate service industries. Despite the obvious political motivations, the United States should shift its focus from autos and agriculture to boosting service sector exports (finance, business services, intellectual property, etc) where it enjoys a significant comparative advantage.
• Germany must do more to increase domestic spending, reduce its current account surplus, and lower its bilateral surplus with the USA.
• At some stage, America’s growing twin deficits will be a headwind for the US dollar during the next two years. Likewise, the Trump Administration’s unorthodox (at least I am still diplomatic!) pro-growth framework is negative for the greenback.  Near term, however, the combination of loose fiscal and tighter Federal Reserve monetary policies (especially combined with a dovish ECB) will lead to a further dollar appreciation towards Euro 1.10.
• Europe will push back against Trump’s aggressive trade policies. Chancellor Merkel views Donald Trump as an unreliable partner, which will require a more independent (Asia-focused) European trade policy. The fallout from the G7 meeting will reenforce this opinion.  I expect this new direction to begin to emerge from next week’s crucial Europe Union summit.