The Delusion of a Transatlantic Economic Divorce

A year after Liberation Day, Washington and Brussels are still fighting each other—not China.

Liberation Day was meant to reset global trade. It has not. America’s fiscal and trade deficits remain near record highs, while China’s export surge continues unchecked, with Europe increasingly exposed. Washington misdiagnosed the problem, targeted allies, and in doing so weakened the coalition it needs to address China’s distortions.

The transatlantic relationship was further damaged when the United States threatened to invade Greenland and went to war against Iran in concert with Israel, sending an energy shock through the economies of its allies in Europe and Asia. Both sides of the Atlantic may now look to unwind their economic interdependence.

As the U.S. becomes harder to deal with, some even argue Europe should engineer a pivot to China. Europe’s dependence on Chinese technology will deepen as oil and gas prices surge from the Iran war. But the broader premise of this argument does not survive contact with economic reality.

The transatlantic economy remains the world’s largest, with roughly $1.6 trillion in annual trade and several trillion in cross-border investment. European investors alone hold around $8 trillion in U.S. debt and equities, while Chinese investment in Europe is a fraction of that. The task is not to unwind interdependence but to manage it. That means rebuilding transatlantic coordination, sector by sector, around shared exposure to China’s distortions.

Global imbalances had been widening long before the second Trump administration took a sledgehammer to the trading system. The global economy rests on an unstable equilibrium: Chinese supply—fueled by industrial subsidies worth 4.4% of the country’s GDP—meeting debt-fueled U.S. demand. Last year, Washington signaled it would no longer sustain this equilibrium and imposed broad tariffs on allies and rivals alike, culminating in Liberation Day.

As with its other trading partners, Washington went to great lengths to highlight Europe’s overall trade surplus, particularly in goods. It also pushed back against what it sees as regulatory discrimination against U.S. companies, particularly in tech—a dubious claim given the U.S. runs a large services surplus with the EU and that American firms dominate markets such as cloud computing, where three U.S. hyperscalers hold two-thirds of European market share.

Finally, Washington sought to align Europe with a tougher stance on China—arguably its most important objective, but one it has since largely abandoned. The trade conflict with Europe was also bound up with a parallel demand that the continent should shoulder more of the burden for its own defense and security through higher NATO contributions.

With war raging in Ukraine, it was precisely that defense dependence that led the EU to negotiate rather than retaliate against Liberation Day tariffs. The result was the EU-U.S. trade deal signed at Turnberry, Scotland, in which America kept a baseline tariff of 15% on most goods from the EU, and the EU slashed its (already quite low) tariffs on U.S. imports to zero.

The deal is widely seen by European leaders as unbalanced but nonetheless better than no deal at all. Other U.S. allies including South Korea and Japan struck similar deals with tariffs at or around 15%. Even after the Supreme Court curtailed emergency tariff powers, European leaders have shown little appetite to reopen Turnberry.

An Unhelpful Deal

Even if it remains in place over the long term, the Turnberry paradigm will fall short on its own terms in three critical ways.

First, if the objective was to reduce the bilateral trade deficit with Europe, it is puzzling that pharmaceuticals—one of the largest contributors to the U.S. deficit—were largely excluded. For years, U.S. firms have shifted intellectual property and profits offshore, and the 2017 Tax Cuts and Jobs Act entrenched these incentives by taxing foreign income more lightly than domestic income. In effect, the U.S. ratified a pharmaceutical business model based on offshoring, particularly to Ireland.

As Council on Foreign Relations senior fellow Brad Setser has argued, this has driven a surge in EU pharmaceutical exports that is often mistaken for competitiveness but in fact largely reflects U.S. tax policy. Roughly half of the EU’s trade surplus with the U.S.—around $100 billion—can be thought of as “trade in tax.” Strip out pharmaceuticals and the imbalance looks far smaller: EU goods exports fall to around $400 billion, against $300 billion in imports.

Second, the Liberation Day tariffs misdiagnosed Europe as a key contributor to global imbalances when the problem lies overwhelmingly with China.

As its real estate bubble burst in 2021, China shifted from property-led growth to focus even more heavily on exports—a shift fueled by massive industrial subsidies and credit to industry. With domestic demand weak, exports have become the Chinese Communist Party’s main outlet. China’s $1.2 trillion goods surplus has surged to unprecedented levels: its manufacturing surplus now dwarfs those of Europe and Japan. In fact, China’s manufactured-goods surplus exceeds $2 trillion, on par with Italy’s national income.

Europe is now confronting a version of the China shock that America absorbed two decades ago. But the roles have reversed: the first China shock hit labor-intensive sectors such as textiles and consumer electronics in the U.S. The second is striking the core of Europe’s industrial economy: cars, chemicals, machinery and aerospace—sectors China’s industrial policies have rendered increasingly competitive. Germany is ground zero. Its industrial production has fallen back to roughly 2004 levels, hit by an energy shock from Russia’s invasion of Ukraine and a persistent drag on exports from intensifying Chinese competition.

In principle, this should form the basis for cooperation: Europe and the U.S. share an interest in curbing China’s subsidies, battling its currency distortions, and pushing the country toward raising domestic demand. For these reasons, the EU is de facto aligning with the U.S. on steel: the bloc has imposed 50% out-of-quota duties to curb Chinese dumping. But the Trump administration has nonetheless kept its tariffs on EU steel, and so far is unwilling to compromise.

While China’s surpluses swell, Europe’s role in global imbalances is quietly shrinking, a shift that few in Washington appear to have fully grasped. In fact, the eurozone is the only large economy undergoing a true rebalancing. Germany’s decision to abandon the debt brake and enable around $1 trillion in defense and infrastructure spending marks a structural shift. Even the so-called “frugals” such as Finland are set to loosen fiscal policy in response to defense needs. As a result, the euro has appreciated in value, Germany’s external surplus is shrinking, and the eurozone’s overall surplus has effectively disappeared absent Ireland’s tax distortions.

Europe’s defense policy is also reshaping the terms of the transatlantic relationship. The EU has introduced the €150 billion SAFE program, aiming to raise its share of defense procurement from European industry to at least 55% by 2030. Washington may lament reduced purchases of American equipment, but cannot have it both ways: if it wants a Europe capable of defending itself, it cannot also expect it to remain dependent on U.S. suppliers.

Washington’s strategy has left Europeans puzzled. Rather than building a joint front against China, the U.S. has prioritized a deal with Europe that ultimately does little to address its trade imbalance.

One key casualty has been coordination on China’s currency manipulation. The U.S. has traditionally led efforts in this area but is now absorbed in multiple trade conflicts. France has put the issue on the G7 agenda, and German Chancellor Friedrich Merz raised it during his visit to Beijing in late February. But Europe lacks the experience of global macroeconomic and foreign exchange coordination that Washington has.

Third, the transatlantic economy is marked by a division of labor neither Washington nor Brussels can simply wish away.

Led by Germany, Europe outproduces the U.S. in steel, vehicles, ships, and civil aircraft. Manufacturing plays a far larger role in Europe than in the U.S.: it accounts for 16.4% of value added there versus 11% in the states, and employs around 30 million people compared with 13 million. Because American industrial capacity cannot meet domestic demand, the EU has long run a surplus in goods trade with the U.S. dominated by machines, cars, and chemicals, while much of America’s advanced manufacturing has effectively been outsourced to Europe and Asia.

A Call for Cooperation

That structural reality now collides with Washington’s attempt to reindustrialise and rebalance this relationship. Tariffs alone are unlikely to bring manufacturing back at scale in an economy operating at or above full capacity, as shown by sluggish U.S. manufacturing growth for most of 2025. If the U.S. does not want to deepen its dependence on China, its best shot would be to continue importing Europe’s manufacturing surplus.

Europe, for its part, remains heavily reliant on the U.S. for technology, artificial intelligence, and software services. It may seek to de-risk from U.S. finance, the dollar, and American tech, but U.S. advantages in research and development, scale, and innovation make any deeper decoupling unrealistic. Both sides therefore face the same choice: deepen dependence on each other, or on China.

Some in Europe argue the EU should pivot to China instead, following the lead of Canadian Prime Minister Mark Carney. But this too does not survive contact with economic reality. For a start, Canada sells commodities China still imports, and Europe does not.

Besides, China’s challenge is not only economic but strategic. A system that exports relentlessly, imports far less and channels subsidies into advanced manufacturing does more than distort trade: it reshapes the industrial base of its partners. The U.S. offers a cautionary case. Despite unmatched defense spending, decades of offshoring have left bottlenecks in the manufacture of munitions, electronics, and machine tools, limiting the Pentagon’s ability to scale production.

Modern warfare increasingly draws on civilian technologies—semiconductors, batteries, software, and advanced manufacturing systems. China illustrates this convergence, moving from electric vehicles into semiconductors and from drones into autonomy and sensors. At a moment when industrial depth underpins military capability, the EU and U.S. should align their industrial bases to gain economies of scale. Fragmentation among allies is strategically self-defeating.

What, then, could a common transatlantic policy look like? Both the U.S. and Europe would benefit from tighter coordination through sectoral “clubs” if they want to preserve some of the gains from trade—greater market scale, specialization, and competition.

Under Presidents Trump and Biden, the U.S. imposed high bilateral tariffs on China, only to find such measures lead to the relocation of final assembly to third countries such as Southeast Asia or Mexico. The EU is about to learn that lesson the hard way. Its Industrial Accelerator Act equips base chemical and steel industries, clean technologies like heat pumps and wind turbines, and the automotive sector with local content requirements cutting out China—while remaining open to the EU’s 76 free trade partners, inviting the rerouting of embedded Chinese content.

In the medium term, forming a “tariff club” with like-minded partners would be a more effective response to China’s overcapacities. The EU and U.S. account for a large share of global demand in many advanced industrial sectors, so a strong alliance could leave Chinese exporters with few markets of comparable scale. In practice, this would mean China absorbs more of the tariff burden through lower export prices and margins, rather than passing it on in full to consumers. The effect is not guaranteed, but it is far more likely under coordinated action than under unilateral tariffs.

There is a swath of sectors where such coordination would be promising. It need not always be formal: a de facto club already exists in electric vehicles, where the U.S., EU, Brazil, and Turkey have imposed tariffs on Chinese imports. Priorities will diverge in some areas—such as wind turbines—but align in others, including batteries, rare earths, and active pharmaceutical ingredients, where China’s near-monopoly poses a profound coercion challenge to both the U.S. and EU. In advanced engineering sectors such as aircraft, both sides have an interest in competing with China’s Comac, whether through launch aid for Airbus or U.S. government support to help Boeing recover and innovate again.

The litmus test is rare earths, which China has repeatedly weaponized with sweeping export controls, threatening to bring European and American manufacturing to a standstill. In principle, this is precisely where a transatlantic “club” should emerge: scaling up alternative supply chains, coordinating stockpiles and providing long-term price support to producers outside China.

The Trump administration has intermittently embraced coordination, but often in ways undermining its own aims. It has prioritized domestic stockpiling, disbursed subsidies inefficiently, and signaled that cooperation with allies remains subordinate to “America First” principles. Building rare earth supply chains is a decade‑long effort requiring trust. That trust is in short supply.

For now, this state of affairs makes genuine coordination difficult. Europe will have to provide some of the demand for rare earths while other key partners able to provide supply—notably Australia and Canada—are wary of being drawn into an overt anti-China bloc. But the underlying logic is solid. The scale of China’s dominance and the risks it poses to industrial and defense supply chains are simply too large to ignore. Over time, necessity is likely to force coordination on rare earths and beyond, whether through formal clubs or looser alignment.

The irony is that the U.S. and Europe are destined to rediscover each other not because trust has been restored but because the alternatives are worse. The premise of a transatlantic economic divorce is misguided. The relationship may be reshaped, but it cannot be unwound—least of all at a moment when both sides face the same strategic challenge from China.