Hold the obituary: Europe comes to life as US stumbles

Germany’s defence buildup is one of several signs Europe might be shaking off stagnation.

Friedrich Merz, leader of Germany’s Christian Democratic Union, casting his vote at the Bundestag this week on legislation that effectively eases the country’s so-called debt brake. Picture: Michael Kappeler / Pool / AFP

At the World Economic Forum in Davos two months ago, the mood around Europe was funereal. Its economy and markets had underperformed the US for years. Now a newly inaugurated President Trump promised to sledgehammer Europe with tariffs while juicing US growth with lower taxes, less regulation and cheaper energy.

As usual, the Davos consensus got it wrong. Since then, the moods across the Atlantic have switched places. European stocks are up nicely, while the American market has had a correction (a 10 per cent drop). On Wednesday, Federal Reserve officials revised their

outlook for inflation up and for growth down. The dollar, which shot up after Trump was elected, has sunk.

US growth prospects have actually slipped since Donald Trump’s arrival. Picture: Jim Watson/ AFP

Some perspective is in order. A market reversal was overdue; the valuation gap between European and American stocks was becoming absurd. Even with revisions, the US is still likely to grow faster than the European Union and Britain this year. Business activity indicators in Europe remain weak.

Yet a more fundamental reappraisal of the two regions’ prospects might be in order, and it has a lot to do with Trump — though not the way most expected.

US growth prospects have actually slipped since Trump’s arrival. In January, economists expected growth of 2.2 per cent annualised in the current quarter. Now, estimates are around 1 per cent to 1.5 per cent. On Wednesday, Fed officials lowered expected growth this year to 1.7 per cent from 2.1 per cent.

The exact reasons for the downgrade are unclear; the first-quarter slowdown reflects data that predated Trump’s first full month in office. Still, his trade war has taken a toll on business and consumer confidence.

Moreover, the risk that tariffs keep inflation above the Federal Reserve’s 2 per cent target means the central bank is for now keeping interest rates at 4.25 per cent to 4.5 per cent, though it hasn’t ruled out later cuts.

European growth prospects haven’t changed much. In fact, the threat of tariffs led the European Central Bank earlier this month to mark down expected growth in the eurozone this year to just 0.9 per cent.

But several positives are pushing in the opposite direction. Though European leaders are nervous about Trump’s eagerness to strike a peace deal in Ukraine with Russian President Vladimir Putin, the prospect has brought European natural-gas prices down.

And with underlying inflation lower in Europe than the US, the ECB has cut rates twice this year, to 2.5 per cent, and will likely cut them again, a useful tailwind to consumers.

Meanwhile, European leaders have been galvanised to act on their stagnant economies, nowhere more than in Germany. This week, its legislature amended its constitutional “debt brake” to effectively permit unlimited defence spending. Evercore ISI, an investment bank, estimates that defence and infrastructure spending will rise by the equivalent of 3 per cent of gross domestic product. The equivalent in the US would be nearly $1 trillion a year.

Military vehicles being assembled at German defence contractor Rheinmetall. Picture: Axel Heimken / AFP

In a memo Tuesday, the conservative party that won last month’s elections and spearheaded the move (on which the legislature’s upper house will vote Friday) said: “We are defending ourselves against attacks on our open society and freedom. At the same time, we are strengthening Germany’s investment opportunities to an unprecedented extent.”

The European Commission, the European Union’s executive arm, is pushing in the same direction, proposing to exempt defence from the bloc’s deficit caps. On Wednesday, it proposed a defence fund of 150 billion euros, the equivalent of $164 billion. Participation by US weapons suppliers would be limited unless America signs a security agreement with the EU.

“WWII got the US out of the Great Depression; Europe’s rearmament should do wonders for Europe’s cyclical outlook,” Stephen Jen and Fatih Yilmaz of Eurizon SLJ Capital wrote this week.

More important than the numbers is the change in mindset. Germany enacted its debt brake in 2009 when its leaders were determined to avoid the instability that excess debt had wrought on its European neighbours.

They succeeded, but at a cost. An aversion to borrowing kept German demand depressed and its trade surplus high while starving the military and infrastructure. Marking the shift in mindset, Defence Minister Boris Pistorius said ahead of Tuesday’s vote: “The threat situation comes before the financial situation.”

Germany isn’t the only place where pro-growth policy is in fashion again. UK Prime Minister Keir Starmer is rolling out permitting reforms to speed up the construction of houses, infrastructure and nuclear power plants. Chancellor of the Exchequer Rachel Reeves vowed this week to ease restrictions on mergers.

France, meanwhile, signalled that it would approve loans to finance six new nuclear reactors, estimated in 2022 to cost €52 billion.

These steps could take years to bear fruit, and there’s no guarantee execution will match intent. Still, it’s notable that political leaders have mustered the intent. Why now? Trump can take some credit, though not in the way Europe would want. His overtures to Russia, ambivalence toward the North Atlantic Treaty Organisation and promised tariffs have created in Europe an urgency around rearming and breaking down internal barriers to investment and innovation.

German conservative leader Friedrich Merz, likely the next chancellor, said last month that it is clear Trump “does not care much about the fate of Europe. My absolute priority will be to strengthen Europe as quickly as possible so that, step by step, we can really achieve independence from the USA.”

French President Emmanuel Macron last month cited Trump’s mantra “drill, baby, drill” to tout his own agenda of boosting nuclear-generated electricity: “Here there is no need to drill, it is plug, baby, plug.”

French President Emmanuel Macron’s agenda includes plans to boost nuclear power generation. Picture: Ludovic Marin/ AFP

Trump isn’t just changing the policy calculus in Europe. In China, his tariffs are easing the way for more fiscal stimulus. Andrew Batson of Gavekal Research estimates that China will run a budget deficit of 10.9 per cent of GDP this year, its largest ever, bringing additional stimulus equal to 2.4 per cent of GDP.

These figures “run counter to the popular narrative that China’s deep-rooted fiscal conservatism is preventing it from responding appropriately to an economic slowdown,” Batson wrote.

There is an irony here. If Europe and China succeed in firing up internal engines of growth, that could, along with the weaker dollar, help narrow their trade surpluses with the US tariffs would have achieved Trump’s goal of reducing the trade deficit, but not the way he expected.

The Wall Street Journal