Storm Clouds over the European Economy

Troubles are coming to the European economy not as single spies but in battalions. Those troubles include an Iranian-induced oil and food price shock, a 25 percent US import tariff on European automobiles, a slowing world economy, higher interest rates, and the threatened removal of the US security blanket over Europe. These troubles could precipitate a European economic recession, cause serious debt problems in some of Europe’s largest economies, and put an end to any hope of the Euro seriously competing with the dollar as the world’s dominant international reserve currency anytime soon. Even before the Strait of Hormuz’s closure, the European economy was not in good shape. Economic growth was sluggish, and three of Europe’s four largest economies had unsustainable public finances. After growing by a little over one percent in 2025, Europe’s GDP growth slowed to a snail’s pace of 0.1 percent in the first quarter of this year, while in April its Purchasing Managers Index moved into recession territory. Meanwhile, France, Italy, and the United Kingdom all had public debt to GDP ratios in excess of 100 percent, while France and the United Kingdom had budget deficits of five percent of GDP. This leaves Europe with little fiscal space to deal with any future economic downturn. The closure of the Strait of Hormuz has again exposed Europe’s energy import dependence. Unlike the United States, which is energy self-sufficient, Europe imports around 60 percent of its energy needs. This has exposed it to the approximate doubling in the Brent oil price to its present level of around $110 a barrel and to a 40 percent increase in natural gas prices. It has also exposed Europe to potential physical shortages in energy products should the Strait of Hormuz remain closed for much longer. Like the rest of the world, Europe is likely to be exposed to higher food prices towards the end of this year as a result of the Iran-induced sharp rise in fertilizer prices. Many fertilizer prices have now risen by upward of 50 percent in the wake of the Straits’ closure. It also has to be of concern to Europe, as it is to the rest of the world, that some 30 percent of the world’s helium production and 10 percent of the world’s aluminum production have been interrupted as a result of the Persian Gulf crisis. A prolonged shortfall in helium supply could have a crippling effect on semiconductor production. That in turn could negatively impact the automobile sector and other industries reliant on semiconductor inputs. Unlike the Federal Reserve, which has a dual price and employment mandate, the European Central Bank (ECB) has a single mandate of price stability. This leaves the ECB with little option but to increase interest rates at a time of economic weakness to keep inflation at close to the ECB’s two percent inflation target. Anticipating the ECB’s likely shift to monetary policy tightening, Eurozone long-term interest rates have increased by around 50 basis points since the start of the Iran war. Yet another strong headwind with which the European economy will have to contend is the recent hike in US import tariffs to 25 percent on European automobiles. Underlining the significance of these tariffs for Europe’s economic outlook are the facts that the US is the largest market for European automobile exports, and automobile production accounts for some seven percent of Europe’s GDP. A European economic recession and higher government borrowing rates will make it difficult for Europe’s highly indebted countries like France, Italy, and the United Kingdom to grow their way out from under their debt mountains. So too will political pressure to provide energy subsidies and to increase defense spending. The pressure for increased defense spending is now more pressing, given that Trump keeps reminding Europe that he is very dissatisfied with its response to his request for help in clearing the Strait of Hormuz and that he might want to withdraw from NATO. All of this would seem to make the European economy more vulnerable to a prolonged closure of the Strait of Hormuz than the US economy. Such a closure would heighten the chances of a European economic recession and of renewed debt problems in countries many times the size of Greece. It would also put an end to the idea that the Euro could pose a challenge to the dollar anytime soon. The post Storm Clouds over the European Economy appeared first on American Enterprise Institute - AEI .