Valentine's Day: America and Europe's trade breakup

Washington picked Valentine's Day to publish its Reciprocal Trade Memorandum, a cold message to its main trading partners across the Atlantic. The document sets out a rigid framework that would require equal tariff schedules and matching non-tariff barriers for European goods. The euro zone is already losing industry and short of domestic demand, and the memorandum goes straight at the export model on which it depends.

A grievance about cars

The memorandum instructs trade officials to study each partner's duties, taxes and regulations before setting a matching American levy, so the damage is deferred rather than avoided. Europe offers easy targets for such a review. The European Union charges a 10 per cent tariff on imported cars while the United States charges 2.5 per cent, and American officials have spent years citing that gap as proof of unfair treatment. They say less about the 25 per cent American duty on light trucks, which protects the most profitable part of Detroit's business.

That truck tariff is itself a relic of a transatlantic quarrel. In the early 1960s the European Economic Community raised duties on imported American chicken, and Washington retaliated in 1964 with a levy on light trucks, among other goods. The chicken dispute faded; the truck tariff stayed and shaped the American car industry for six decades. The episode suggests that retaliatory duties, once imposed, tend to outlive the grievance that produced them.

Taxes counted as tariffs

The memorandum casts its net wider than tariffs. It names value-added taxes as a barrier to American exports, even though VAT is charged at the same rate on domestic and imported goods and refunded on exports under rules the United States has accepted for decades. Counting VAT turns a modest tariff gap into a large one, since standard VAT rates across the EU mostly sit around a fifth of the sale price. It also puts the demand beyond the reach of any trade negotiator, because Brussels cannot abolish the tax systems of its member states to please Washington.

Europe has more to lose

The euro zone relies on selling more goods abroad than it buys, which leaves it exposed to American tariffs. Foreign trade is a fairly small share of American GDP. Germany and northern Italy, by contrast, lean heavily on exports of capital equipment, cars and luxury goods for their corporate earnings. A border levy of 10 to 20 per cent on sales to their biggest and most profitable outside market could push manufacturing on Europe's periphery into a deep downturn.

The timing could hardly be worse. Germany's economy shrank in both 2023 and 2024, the euro zone economy stalled in the final quarter of last year, and German voters go to the polls on February 23rd with industry's decline a central issue. The United States is the largest single market for German exports, so a tariff aimed at Europe lands first on the country least able to absorb it.

Not every European exporter is equally exposed. Makers of luxury goods sell to wealthy buyers who notice price rises less, and can pass on much of a levy. Mass-market carmakers and machinery firms compete on price and cannot. Some of the German car groups also build heavily in America: BMW's plant in South Carolina ships many of its SUVs back across the Atlantic, so a European counter-tariff on American cars would hit a German company first.

The euro takes the first hit

Currency desks sold the euro hard as interest rate differentials moved further in the dollar's favour. The European Central Bank can hardly raise rates to support the currency while its own economic indicators are slowing fast. It has already cut its deposit rate five times since last June, to 2.75 per cent, and the next move is more likely to be another cut than a pause, which keeps the pressure on the exchange rate.

A weaker euro does soften the blow for exporters, since it lowers the dollar price of a German machine before any tariff is applied. The relief is partial. European firms pay for energy and many raw materials in dollars, so the cheaper currency raises their costs even as it helps their sales.

Lessons from the steel fight

The last transatlantic dispute offers a guide to how Brussels responds. When Washington imposed steel and aluminium tariffs in 2018, the EU retaliated with duties aimed at politically visible American goods such as bourbon, motorcycles and jeans, and the quarrel took more than three years to settle. Since late 2023 the EU has also had an anti-coercion instrument that allows measures beyond tariffs, including limits on services and public procurement. Brussels has also floated buying more American liquefied natural gas, a concession that would cost it little.

Services give Brussels its sharpest weapon and its biggest risk. The United States sells more services to Europe than it buys, from cloud computing and software to financial advice, so the anti-coercion instrument could target the very firms that make America's trade with Europe look balanced once services are counted. Using it would escalate a goods dispute into one over digital regulation and American technology companies, which is exactly the fight the administration has signalled it wants to pick.

What would change the call

The case against gloom is that the memorandum is a study, not a schedule, and European negotiators have weeks to offer a trade: lower car tariffs or larger energy purchases in exchange for exemptions. A quick deal of that kind would limit the harm to a few sectors. Signs of American duties on European cars, or of the EU preparing its anti-coercion tools, would point the other way. The ECB's meeting in early March, and the coalition that emerges from the German election, will show whether Europe answers with cheaper money, more public spending or both.

For now the calendar favours Washington, which can set the terms while Europe is distracted by a German election and weak growth. Europe now has two bad options. It can retaliate and start a tariff spiral that damages its own factories, or it can accept a lopsided trade regime that would leave its exporters permanently less profitable. Either way, German and Italian manufacturers are likely to pay first, with carmakers and machinery firms taking the hit to earnings before the summer.