The euro area can protect its growth from trade problems

  • The European Union wants to block the extraterritorial reach of U.S. legislation, and to circumvent American sanctions on Iran, with half-baked and untested measures.
  • No matter how that plays out, the impending trade clashes will damage the European and American economies.
  • As a more compact structure within the EU, the euro area can use fiscal and monetary policies to offset some of the depressive impact of weaker external demand.
U.S. President Donald Trump (R), French President Emmanuel Macron (L) and German Chancellor Angela Merkel (C) at the start of the first working session of the G-20 meeting in Hamburg, Germany, on July 7, 2017.
John MacDougall | AFP | Getty Images
U.S. President Donald Trump (R), French President Emmanuel Macron (L) and German Chancellor Angela Merkel (C) at the start of the first working session of the G-20 meeting in Hamburg, Germany, on July 7, 2017.

The long-brewing trans-Atlantic train wreck now seems inevitable. A temporarily suspended trade fight between presumably closest friends and allies has entered an unpredictable crisis following America's unilateral trade and political sanctions against Iran.

Washington's edict that "those doing business with Iran cannot do business with the U.S." is being challenged with sound and fury — but little else — by the EU Commission, with a reportedly strong declaratory support from Russia and China.

That is an ominous development, although, formally, the EU's move to establish, and enforce, its sovereign legislative domain could be an entirely plausible act.

Regrettably, nearly two years of allied discussions about Washington's intention to renegotiate an allegedly unsatisfactory nuclear agreement with Iran have ended up in the worst ever confrontation within the trans-Atlantic community.

Immediately at stake is nearly a trillion-dollar trade business between the U.S. and Europe, with millions of jobs threatened on both sides of the Atlantic. Most of that business is captured by the 19 countries of the European monetary union – particularly by Germany, France, Ireland, Italy and the Netherlands.

Show the good side of the euro

If, as seems likely, the sanctions dispute with the U.S. were to escalate, those would be the countries with the most to lose because alternative markets for $300 billion of their export sales might not be readily available.

Still, it is important to keep those events in the proper perspective.

At the moment, the euro area economy is doing well. The current growth dynamics are keeping demand and output moving forward at twice the speed of the system's estimated potential and noninflationary growth. Apart from that, the fiscal and monetary policies have plenty of room to support economic activity and employment creation.

A 2.3 percent average annual growth in the first two quarters of this year is way above the euro area's estimated growth potential of 1.2 percent. In other words, the economy is hitting beyond the physical limits to growth that are set by the stock and quality of the human and physical capital, and are roughly approximated by the sum of the growth rates of productivity and labor supply.

So, if you want to keep the score, chalk that strong euro area growth up to the European Central Bank. Against all the odds — such as Germany's systematic opposition to monetary accommodation and Berlin's unrelenting pressure for a pro-cyclical fiscal austerity — the ECB managed to pull the euro area out of a deep recession and to set it on a path of accelerating economic activity.

And, in case of need, that steady growth momentum can be further — and safely — underpinned by fiscal and monetary policies.

On the fiscal side, Germany and the Netherlands, the two largest budget surplus countries, have plenty of room to expand domestic demand, and to allow their euro partners to sell more goods and services. That would support growth in the euro area and reduce the depressive impact of excessive German and Dutch trade surpluses — 8 percent and 10 percent of GDP, respectively — on the rest of the monetary union.

Destructive mercantilist pressure

But whether they do that is a different matter. Based on their past, they won't. And the French, the Italians and the Spaniards will just keep quiet, pushed into a corner and chastised as spendthrifts and underperformers. In fact, those countries should vigorously push back, telling the Germans and the Dutch to stop living at their expense and to pursue, instead, a proper economic policy coordination to keep the euro area stable, balanced and prosperous.

The French — continuing to live the illusion of the mythical French-German couple — are finally doing something for themselves. They are allowing the budget deficit for 2019 to increase to 2.8 percent of GDP from 2.6 percent this year. A deeply unpopular government — with the president's latest approval rating sinking to the record-low 29 percent – seems to have understood that it had to shed the German pressure, and to moderate its ill-advised and growth-stifling reformist zeal.

Italy's new "Italians first" government is doing the same thing. Next year's budget deficit is projected to rise slightly to 2.4 percent of GDP from 2 percent this year. Italy is trying to help 6.5 million of its citizens living in utter poverty, and to step up investments to rebuild the country's crumbling infrastructure. Those efforts are taking place at a time of Italy's near-stagnant economic growth and a 10.4 percent unemployment rate, where 30.8 percent of Italian youth remain without a job and a meaningful future.

On the monetary side, the ECB is facing a benign inflation picture. The core consumer price index in August grew at an annual rate of 1.2 percent, marking a stable pattern since the beginning of the year. The annual growth of hourly labor costs in the first half of the year was also stable at 2.1 percent. With an estimated 0.8 percent in labor productivity gains, that gives a 1.3 percent increase in unit labor costs, showing that the underlying inflation is correctly indicated by the core CPI increase of 1.2 percent.

The euro area price stability, and the euro's steady trade-weighted exchange rate, constitute an appropriate background for a gradual withdrawal of monetary accommodation in the months ahead.

Investment thoughts

A total and irrevocable disagreement between the U.S. and the European Union about an ill-fated nuclear deal with Iran, and changes to the existing multilateral trading regime, are old news.

The new development is that Europeans have moved to block the extraterritorial reach of American legislation. They have also officially announced last week the establishment of an apparently flimsy "Special Purpose Vehicle" to circumvent U.S. sanctions on Iran, and to make it possible for the EU, and companies from other jurisdictions, to do business with the Islamic Republic.

Predictably, Washington has responded with dismay and a determination to break up the European sanctions-busting contraption.

The allied trans-Atlantic community is facing a serious existential threat. No matter how that plays out, things have gone so far that trade relations between the world's two largest economic systems will be impaired to the point of causing considerable damage to themselves and the rest of the world.

The 19 euro area economies have the means to limit the fallout of the impending trade clash. The area's current growth dynamics are good, and its fiscal and monetary policies have plenty of room to offset the expected weakening of external demand.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.