With its economic growth of 1.65% in the first half of this year, the European Union is hitting the physical limits to its demand and output.

That partly explains the European Central Bank’s reluctance to ease credit conditions to offset fiscal tightening in several major member country economies.

The short-term outlook is changing, though.

Germany’s stagnation is likely to worsen owing to increasing trade limitations in its major export markets. France’s political upheaval will most probably continue; its governments’ stability is very much in question as the country faces strongly contested spending cuts and tax hikes. Italy and Spain also face similar pressures while having to deal with high budget deficits and excessive public debt.

Trade with the rest of the world, therefore, remains as a potentially important source of support for their economic activity. But, there again, significant problems have arisen with new import tariffs in U.S. trades and de-risking policies in trade and investments with China.

U.S. and China are E.U.’s largest trade partners, accounting for $1.1 trillion of its trade volume in the first seven months of this year.

Hardening partition lines

Apart from significant impediments to bilateral trade, Washington is also asking the E.U. to set very high trade tariffs on all the countries buying Russia’s energy products. That primarily concerns E.U. trade partners like China and India.

And the latest hit at E.U. trade policy is the U.S. call on all G7 and NATO members to introduce import tariffs against their trade partners purchasing oil and gas from Russia.

These are the calls the E.U. may find very hard to ignore. The U.S. is E.U.’s by far the largest trade partner. In addition to a significant trade policy realignment,  the E.U.-based companies will now be facing strong competition because America has relatively well positioned product and service substitutes for more expensive E.U exports.

Germany, France and Italy – two thirds of the euro area economy -- are the largest U.E. exporters to American markets. To hold on to their U.S. market shares, they will have to absorb a significant part of higher import tariffs, or to hop over trade barriers and invest in U.S.-based production facilities.

Either way, the initial impact of such measures would depress their economic activity at a time when they are experiencing a stagnating and slowing growth of demand and output.

Germany is a case in point. Its weakening $92 billion export sales in the U.S. during the first seven months of this year will continue to decline. That will strongly depress the economy where exports account for half of the country’s GDP. In fact, current estimates point out that Germany’s falling net exports will this year shave off 1 percent of economic growth, leaving the GDP on a verge of another recession – after two consecutive years of negative growth.

Trade challenges ahead

Germany, of course, could easily get out of this recessionary bias by stepping up government spending to offset declining exports, investments and stagnating household consumption. A relatively low budget deficit of 2.7% of GDP and a stable public debt of 63% of GDP leave enough room for a safe fiscal easing, but the governing coalition apparently faces no political pressure to end the country’s economic weakness.

So, true to form, Berlin is forcing its businesses to step up exports to survive.

But this time is different. With its rising import tariffs, Washington will no longer oblige, while China is unhappy with Germany’s de-risking policy. That’s a euphemism Beijing takes as a call to limit bilateral trade and investment transactions with the European trading bloc. And German sales to China dropped 5.2% in the first seven months of this year.

The most important point to note here is that Germany is effectively running the E.U.’s foreign trade policy. That raises three key policy issues in the months ahead.

First, being the largest E.U. economy Germany is expected to lead the trade bloc’s business cycle. Under current circumstances, that means that with a large current account surplus of 6% of GDP and a relatively sound fiscal position, Germany should strongly stimulate its domestic demand to prop up the E.U.’s weakening economy.

Second, the U.S.-E.U. trade policy is set -- for now -- but Germany will have a crucial role to play regarding the allied trade policy with respect to the rest of the world.

Third, China and India loom large in that context. Germany’s automobile and chemical industries have staked their future on trade and investments in China -- and, led by Germany, the E.U. is rushing to conclude a free trade deal with India by the end of this year.

What will Washington do about all that?

The E.U. trade policy is facing serious challenges as current geostrategic partition lines seem likely to harden over the foreseeable future.