Hegemonic stability in times of change

A month ago, the global economy found itself subject to an effective US tariff of 30% (3% before L-Day) and there was a feeling that only the behaviour of the bond markets was managing to inject some sense into the trade negotiations which, amid all the chaos, had too many open fronts for the American administration. The state of the trade conflict in the first week of June reflects a slight de-escalation of tensions as we await the Court of International Trade’s final decision given that, along the way, the US has reached an agreement with the United Kingdom and has signed a truce with China to reduce the reciprocal tariffs for 90 days. All of the above has lowered the average tariff to 14.6% (around 40% with China and 10% for the rest of the world), including the latest hike to 50% for tariffs on steel and aluminium. Moreover, this reflects a realignment in the Trump administration’s delicate strategy as it aims to minimise the short-term damage while seeking a rebalancing that is beneficial to the American economy in the long term.

Therefore, as the summer gets underway, US import tariffs are at levels compatible with an orderly slowdown in global economic activity. In our baseline scenario, with an average tariff of around 10%, global growth would be 2.9% (1.2% for advanced economies and 3.2% for emerging economies), with the euro area growing at a rate of 0.9% (2.4% in Spain), supported by the fall in energy prices (around 25% in euros so far this year) and by a monetary policy that is expected to reach neutral territory in June. The country hardest hit by the trade hostilities in the short term will be the US itself, with a much worse combination of growth and inflation in 2025 (1.3% and 2.9%, respectively) compared to that expected prior to the announcement of the tariff hikes, bringing it dangerously close to stagflation. This divergence on either sides of the Atlantic, with Europe faring better for the first time in a long time, continues to be reflected both in the behaviour of the financial markets and in savings flows and exchange rate movements. The problem is that, after four months benefiting from the pre-L-Day inertia and from purchasing decisions being brought forward, the pattern in global economic activity will experience a clear shift in the middle of the year; it is difficult to anticipate the combined effect of the tariff disorder, the geopolitical uncertainty, rising inflation in the US and the sharp depreciation of the dollar, both on the decisions of consumers and businesses and on financial asset prices.

This is particularly the case given the new elephant in the room, namely the US fiscal situation currently undergoing a budget negotiation process, bearing in mind the current levels of the public deficit (6.5% of GDP), public debt (120% of GDP) or the high cost of debt servicing (3.8% of GDP). Such fiscal indicators are hardly compatible with the maximum rating which Moody’s was assigning to US debt (AAA) prior to its recent downward revision. In this context, the yields on 10-year or 30-year bonds (4.4% and 4.95%, respectively) will be highly sensitive to the budget currently being debated in the Chambers and which includes some rather concerning aspects, such as Section 899 which could penalise international investment. This is especially the case due to the perceived distrust of the dollar among a large number of investors. That said, the evidence suggests that the movement of recent weeks is more of an intense (and rather disorderly) correction rather than the first signs of any structural change in its traditional role as the global reserve currency, given that it continues to trade 19% above the average of its real effective exchange rate of the past 20 years. However, as Martin Wolf recently reminded us using the theory of hegemonic stability, the equilibrium of an open world economy depends on the existence of an economic power that is capable of offering essential public goods, open markets for trade and a stable currency, in addition to becoming a lender of last resort when needed. The US has been able to play such a role since 1945. The question is whether this is compatible with the Trump administration’s strategic shift, which appears to be seeking a partial or full retreat by the world’s leading power to its winter barracks. This would leave the world economy orphaned from that economic stabiliser, given that China, in the short term, does not appear to be in a position to offer such leadership. Therefore, with geopolitics gaining prominence at times, the design of the new world economic order will pivot on the strategic game between these two economic realities (the US and China) which threaten to overlap, after following parallel trajectories over the past few decades. These parallel trajectories did, however, generate concurrent macroeconomic dynamics and, in the end, they were mutually beneficial.