How To Respond to the (Stupid) Tariff War

Europe needs to avoid a protectionist response, as this will only exacerbate tensions rather than ease them. Above all, it is fundamental to maintain an open, rules-based market system to sustain growth in the long term.

The amount of European exports to the United States, which seems to be one of Donald Trump’s obsessions, could be reduced in various ways. Imposing tariffs on imported European goods as the American president wants to do is certainly one way, but it is the stupidest and one of the least effective measures, even for the U.S. A more intelligent way of doing it would be to increase internal demand in Europe (more consumption, more investment, or even more public spending) without introducing new tariffs.

Even a euro that was stronger against the dollar would reduce European exports to the U.S., making our goods more expensive for American consumers. Therefore, tariffs are not the only tool. Tariffs are not a good idea because they trigger trade wars, fueled by campaigns on individual sectors or even individual goods: a tariff on Italian prosecco followed in the opposite direction by a tariff on Kentucky bourbon. In the end, everyone loses, and often, it’s precisely the country that triggered the trade war in the first place.

However, let’s assume, as seems to be happening, that Trump has decided to start a trade war not just with the EU but also with China, Canada and Mexico. How should Europe react? This question was the subject of a review commissioned by the European Parliament and carried out by six economists, including this author. This article looks at the results of that study, available through the website noted at the end of this piece.

The study’s first point is that a euro that is weaker against the dollar would mitigate the reduction in European exports to the U.S. brought about by tariffs, improving the competitiveness of our companies in the global market. Flexible monetary policy is thus a crucial tool for mitigating recessionary pressure from American tariffs. However, a poorly calibrated response, such as an excessively restrictive stance from the European Central Bank, could amplify the economic slowdown rather than counteract it. Looking at what happened during Trump’s first trade war with China in March 2018, the Chinese yuan depreciated 13% against the dollar. This depreciation greatly eased the effects of the American tariffs on Chinese exports.

China was and continues to be the main target of U.S. protectionism. We can therefore expect that this protectionism will hit China harder than Europe. As a result, the yuan should depreciate more against the dollar than the euro will, making the euro stronger against the yuan.

The effects of U.S. protectionism and the Chinese response could push Europe into recession, but only moderately. If the euro were left to depreciate in an intermediate position between the dollar and the yuan, the indirect effects linked to the exchange rate would more or less be canceled out. Nonetheless, the ECB has the tools to counteract potential recessionary effects. It is always possible to accompany the American tariffs with a fiscal stimulus in Europe, as is already occurring with the decisions announced by the new German chancellor.

Over and above limiting the tariffs’ effects, a clever use of monetary and fiscal policy would ease the differences among sectors. The previously mentioned study highlights major variations among industries. For instance, those such as the automotive, machinery and pharmaceutical industries are especially vulnerable. A 10% tariff would reduce the demand for these goods by 53%. Depreciating the euro would ease these effects.

There are ultimately two risks. The first is that, spurred by a political wish to target the tech sector — given the strong ties certain Silicon Valley entrepreneurs have with the Trump administration — the EU decides to invoke punitive polices, tightening regulations or excessively increasing taxes on the platforms. Even if well intended, this would be an erroneous choice. It may assist the growth of the European tech sector, but it would slow the adoption of imported technology, compromising the growth of production potential in the EU.

In contrast, a strategy that is focused on diversifying commercial markets and innovation incentives, along with financial flexibility, would help Europe to absorb the negative effects of U.S. trade policies. In particular, reinforcing trade ties with partners other than the U.S. and keeping an open and rules-based market system will be vital to maintaining growth in the long term.

The internal forces which reduce the risk of inflation act slowly through an increase in unemployment and cooling salary increases. However, movement in the exchange rate or the price of imports has a rapid effect on inflation. The ECB could therefore find itself in a situation in which there could be upward pressure on inflation even if core inflation is falling. The main risk in this scenario is that the ECB overreacts, interrupting the current cycle of tax reduction too soon.

In the U.S., on the other hand, there could be a rapid expectation of inflation, anticipating the effects of the tariffs on the U.S. economy. It is crucial that the ECB maintains its focus on the state of the EU economy, even if the Federal Reserve is constrained to move in the opposite direction. A weaker euro is a natural response to the American tariffs.

In conclusion, Europe must avoid reacting protectively as this will only increase trade tensions, rather than ease them. Instead, focusing our strategy on market diversification, innovation incentives and financial flexibility will help us absorb the negative fallout from the American tariffs. Above all, it is fundamental to maintain an open, rules-based market system in order to sustain growth in the long term.

The material for this article comes from a paper commissioned by the European Parliament from six Italian economists from the University of Chicago and Bocconi: Laura Bottazzi, Veronica Guerrieri, Guido Lorenzoni, Tommaso Monacelli, Carlo Favero, and the author of this article, Francesco Giavazzi. The paper is available through a link on the European Parliament’s website.