Silvia Merler is a Non-Resident Fellow at Bruegel and the Head of ESG and Policy Research at Algebris Investments
So far, the European Union’s response to the bewildering flurry of tariff announcements coming out of the United States under President Trump has predictably focused on trade. But economics teaches us that every trade imbalance has a financial counterpart.
The abrupt US turn to protectionism offers a chance to strengthen the international role of the euro as a global reserve currency, and of euro assets as an appealing haven. Europe has the motive, means and opportunity to do it. The question is if it also has the will.
The motive is to be found in the risk of erratic US policy behaviour. The extreme financial market moves triggered by Trump’s tariff announcements are evidence that doubts about the quality of current US economic governance are unlikely to be dispelled overnight.
Taken together, the strong equity sell-off coupled with the rise in US Treasury yields and the weakening of the dollar, point to a previously unfathomable possibility that the unchallenged status enjoyed by US risk-free assets within the global financial system might start to be questioned. In this scenario, the rest of the world may value diversification in safe assets.
The means are EU debt. Since 2020, Brussels has issued almost €600 billion in bonds to finance the NextGenerationEU (NGEU) post-pandemic recovery instrument and other programmes. On a weighted average, EU bond issuance has been 8.3-times oversubscribed since 2020, and yields remain lower than those paid by most EU members – signalling a structurally strong demand for EU debt.
The strong equity sell-off coupled with the rise in US Treasury yields and the weakening of the dollar point to a previously unfathomable possibility that the unchallenged status enjoyed by US risk-free assets within the global financial system might start to be questioned
But supply is currently not set up to meet demand. Almost €200 billion in EU bonds will expire in the next four years and the foreseen issuance of €150 billion under the European Commission’s plan to fund EU defence, ReArm Europe, will only partly offset that. To make a difference in volumes, the Commission should roll over NGEU and commit to policies that would guarantee a stable future supply of EU bonds.
The opportunity resides in Europe’s need to fund a massive increase in defence spending. Defence against external aggression is an obvious European public good, but individual countries may have insufficient incentives or insufficient fiscal space to finance it. The early reactions to ReArm Europe point to the risk of an unlevel playing field in defence spending. While Germany announced a standalone spending plan that almost rivals the size of the entire EU effort, fiscally constrained southern European countries have questioned the logic of issuing more national debt.
A similar risk emerged in 2020 with pandemic-related state aid. At the time, EU members recognised that COVID-19 was a symmetric shock with asymmetric effects and launched the landmark NGEU – a debt-financed investment plan featuring the first ever intra-EU country-level fiscal transfer. The risk of Russian aggression is an equally grave and arguably larger symmetric shock, and it warrants the same conceptual approach.
The EU should thus move to fund the entire cost of its planned rearmament with EU debt, similarly to NGEU. This would ensure appropriate provision of a key European public good at a crucial time, while easing pressure on member states with more limited fiscal space, providing a fiscal stimulus to help counter the risk of a tariff-induced recession, and solidifying Europe’s role as a reliable pillar of the (now fragmented) multilateral world order.
But does Europe have the will? The concepts of joint EU debt and EU fiscal capacity have been controversial. The euro area crisis contributed to making them politically toxic. Proposals have been put forward to structure joint debt in a way that would preserve fiscal discipline – eg. by splitting or tranching it to reduce moral hazard.
But the US example shows that more debt can actually be safer debt if that debt is backed by a reliable fiscal capacity, underpinned by predictable economic policy and managed with the intention of making it a global asset.
The financial market dynamics triggered by US tariffs do not yet amount to a full-blown crisis of confidence, but they could produce a secular change in the multilateral world order. As a consequence, Europe faces a structural shift. In foreign policy, it will struggle to equip itself for its own defence. In economic policy, it is time for Europe to find the courage to be more ambitious and fill the void left by Trump.
This article is based on a Bruegel First Glance.