Germany's cold may give the rest of the EU pneumonia

It used to be said of the U.S. economy that when it sneezed the rest of the world contracted pneumonia. Today, the same might be said of Germany, the eurozone’s largest and most dynamic economy, with respect to the rest of Europe.

The vital importance of a healthy German economy for the rest of Europe is reason for great concern over Germany’s seemingly diminished economic prospects. The recent German economic slowdown is occurring in the context of the other major European economies being beset by economic and political challenges of their own.

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There can be little doubt that recently the German economy has hit a very soft patch. In the second half of last year, Germany very narrowly missed being in a technical economic recession. Meanwhile, since the start of the year, German industrial production and investor confidence have slumped sharply in a manner that has caught most economic analysts by surprise.

Sadly, there is reason to fear that the factors that have contributed to Germany’s most recent swoon will continue, if not become more aggravated, in the period immediately ahead.

As a very open economy, which exports around half of its GDP, Germany has been particularly vulnerable to the recent slowing of the Chinese economy. Should the Chinese economy now be in a secular slowdown and should the U.S. trade war with China not be resolved soon, the highly export-oriented German economy would be among those hardest hit.

A further source of recent weakness in the German economy has been its automobile industry. Not only have German automobile producers found it more difficult than initially envisaged to adjust to tighter emission standards, but it has also been hit by weaker Chinese demand and by Brexit worries.

Now casting a dark cloud over the German automobile industry is President TrumpDonald John TrumpPapadopoulos on AG's new powers: 'Trump is now on the offense' Pelosi uses Trump to her advantage Mike Pence delivers West Point commencement address MORE’s threat to impose punitive import tariffs on German cars to counteract Germany’s very large trade surplus.

The U.S. Commerce Department has already submitted its findings on whether European automobiles constitute a national security risk to the United States. This gives President Trump 90 days to decide whether or not to follow through with his threat to impose a 25-percent import tariff on European and Japanese automobiles.

Hopefully, President Trump will find a way to back off his European tariff threat. However, it is all too likely that with Germany currently running the world’s largest external current account surplus, U.S.-German trade tensions will persist.

This would especially be the case should Germany’s external surplus balloon further as the German economy weakens and as the euro keeps depreciating.

One reason for concern about the risk of a German economic slowdown is that the policy response to such a slowdown is likely to be weak. With European interest rates already very low and with the European Central Bank’s balance sheet already bloated, there is limited room for a European monetary policy response to a German slowing.

Meanwhile, the German government’s fixation with keeping the budget balanced raises the risk that German public spending could be cut in a pro-cyclical manner in the event that Germany did slip into a recession. This raises the real prospect of a prolonged German economic slump.

Equally concerning is the fact that a German recession is the last thing that a troubled European economy now needs. An over-indebted Italian economy is now already in recession; the U.K. economy is being buffeted by investment uncertainty over Brexit; and confidence in the French economy is being seriously undermined by social unrest associated with the "yellow vest movement."

Hopefully, the Trump administration is paying close attention to Europe’s deteriorating economic outlook. Hopefully, it is also mindful of the real risk of another round of the eurozone sovereign debt crisis that could unsettle global financial markets and that could reach our shores.

Maybe then the Trump administration will refrain from making a dismal European economic outlook worse by following through with its proposed 25-percent import tariff on European automobiles.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.