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Economic security and the geo-politicisation of trade

Published 8 February 2024

The last few years have witnessed an increase in interest in the relationship between geopolitics and trade. A spate of recent studies on geopolitical fragmentation has sought to quantify these costs. A recent study by the IMF reported long-term economic costs ranging from around 1% to 12% of Global Value Added (GVA) depending on assumptions about the way in which fragmentation played out. Work by Frontier Economics suggests that the EU’s proposals on strategic autonomy could reduce EU national income per capita in a particular year by around 0.75%.

How do geopolitics interact with trade, and what does this mean for economists seeking to shape policy in a way that avoids some of the costs mentioned above?

Trade and geopolitics: a tangled web that has become a lot more complex

Trade has always been connected to geopolitics. To take just one example, the Most Favoured Nation (MFN) principle that has been the cornerstone of rules-based multilateralism was a response to the geopolitics of the 1920s and 1930s. The US, under President Franklin D. Roosevelt, pushed MFN partly because its exports suffered from the system of imperial trade preferences practised by the UK and other European powers, but also because it saw this system as part and parcel of the bloc rivalry that led to successive world wars.

Over 50 years later, the decision to include China within the scope of MFN through World Trade Organization (WTO) accession also reflected a geopolitical calculation – bring China within the scope of WTO rules and it would be set on a more economically and politically liberal path. That the US and EU have spent the last decade trying to unwind MFN in relation to China to a large extent reflects geopolitical “buyer’s remorse”.

There is, however, a confluence of a number of factors that make the geopolitics of trade qualitatively different now compared to the past, and which, in turn, prompt policies that generate the sorts of costs referenced above.

The first is the way trade works

Everyone now understands the role of global value chains in trade. In principle, the geographic unbundling of production should increase the incentives countries have to get along, so to speak. In practice, this is not necessarily the case. For a start, value added is not evenly distributed across value chains. It is more heavily concentrated in some activities, meaning that countries have incentives to enact policies (such as subsidies) to try and appropriate a bigger share of value added. But beyond that, the unbundling of production has made policymakers and politicians worry about exposure to exogenous shocks (such as with Covid-19). And they are nervous that geopolitical rivals could control key inputs and parts of the value chain, or have access to knowledge that would give them a strategic commercial or military advantage. The concerns are particularly sharp in areas that have dual-use functions (i.e. civilian and military). This is why we have seen selective decoupling between, say the US and China in sensitive sectors such as technological products.

Capitalism without capital

The second issue, and it is connected to the first, is the way economic activity has changed with the rise of “capitalism without capital” i.e. activities based on intangible assets such IP, data, and skills. These are characterised by high fixed costs, near-zero marginal costs, economies of scope and spillovers. Collectively, these features create a strong tendency for concentration. And that, in turn, increases incentives to appropriate these activities and impose costs on rivals. Digital technologies and AI are a case in point. Moreover, intangibles have a big impact as embedded inputs, on the tangible aspects of production, a phenomenon known as servitisation. They also play critical dual-use functions. These sharpen the incentives for policy intervention and rivalry between countries.

Global issues

The third issue lies in the demands placed on policymakers by significant market failures, that are often global or at least transboundary in nature. Climate change mitigation is the most obvious example, because safe atmospheric concentrations of Greenhouse Gases are a pure global public good, and because of the scale of industrial transformation required.

Addressing market failures requires a range of instruments. The main ones are pricing or taxing externalities; regulation; and subsidies. The challenge is that these instruments can be welfare enhancing, if well designed, but are also likely to have an impact on trade and trade partners. Subsidies are a case in point: to be effective, they will need to be both at scale, and specific, in the WTO sense of the word. Moreover, the environmental functions of subsidies are very hard to separate from their industrial functions.

Consider the case of battery technologies for transport and power storage. Their development requires a range of subsidies across technological readiness levels, aimed at tackling market failures associated with early-stage R&D, to those associated with scaling up from laboratory to volume production. There is a clear environmental benefit to this – the ability to decarbonise transport and power systems - but it is also clear that businesses receiving these subsidies will be at a competitive advantage relative to those that do not. That will contribute to tension between trade partners. It also means that efforts to change trade rules to make them more permissive towards subsidies for environmental purposes, while disciplining their more mercantilist aspects, are unlikely to work.

Further complicating the issue is that as much as we speak about dual-use technologies, policies themselves can have multiple designated uses. So, subsidies are not just about ensuring decarbonisation but, as we have just seen with batteries, they are also about securing a competitive edge in green value chains, and enhancing economic security by reducing interdependence on rivals. The Carbon Border Adjustment Mechanism (CBAM) is ostensibly about pricing externalities, but has also been couched in terms of preserving strategic industries and ensuring a level playing field. This tendency of assigning multiple objectives, or repackaging policies to suit the political zeitgeist increases the scope of distortions and complicates attempts to evaluate their costs and benefits.

The role of businesses and the private sector as leading actors in issues of policy concern

Take resilience for example and the reconfiguration of supply chains. Businesses will have incentives to adapt to risks caused by exogenous shocks. What we have come to call real options theory shows how decisions to incur extra cost and build resilience can be profitable beyond what narrow discounted cashflow analysis tells us. The challenge for policymakers is then to develop policy frameworks that help this process. In areas such as sustainability and environmental impacts, businesses have been pursuing or considering cooperative arrangements that can help them tackle negative externalities. Competition authorities face the challenge of how to accommodate these agreements while considering their effects on competitive market dynamics. Such agreements may have trade spillovers too. Less benign influences are the extent to which, in a world with an increased appetite for subsidisation, businesses stimulate subsidies-bidding wars in an effort to capture rents, which then add to the deadweight cost of subsidies.

Internal distributional effects of trade and technological change

This is connected to the earlier point about the rise of intangible activities. These will tend to cluster in specific regions. Moreover, the thrust of recent research into trade has underscored the role of the firm in trade, and the key role that firm-level productivity plays in determining entry into global markets. Productivity is not evenly distributed, and clustering may make this worse. The micro-economic of trade and clustering effects can conspire to worsen inequality.

These are really a matter for internal policy relating to skills, labour market and productivity, and income distribution. But policy failures in these areas are responsible for a backlash against trade, and more specifically trade partners that are blamed for lost local jobs. This creates a political constituency that will buy into geopolitical discourses around national security and sovereignty. But that should not obscure the fact that posturing about external geopolitical issues masks a failure of internal policy geared to addressing distributional issues.

Failing political appetite for containing protectionism in large industrialised economies, notably the US and the EU

The Uruguay Round, the single biggest expansion of multilateral rule making, was possible because both the US Trade Representative and the European Commission wanted to discipline domestic protectionism. What was a solid bipartisan consensus on free trade in the US is now pretty much an equally solid bipartisan consensus against it. The EU long saw rules-based multilateralism as the natural counterpart to its internal expansion based on rules. However, that approach has now given way to the concept of strategic autonomy.

As already observed, much of this erosion of policy support stems from internal policy failures to address the distributional impacts of trade and technology. In that context, the emotional currency of national security makes protectionism an easier sell, and much harder to challenge with objective evidence. It is useful to recall, also, that the economic costs of protectionism are usually measured as deviations from baseline growth. Such reductions in growth rates are real costs: they are missed growth opportunities. But such missed opportunities are hard to spot politically: economists presenting estimates based on counterfactual simulations will be invisible against politicians speaking the discourse of national security. Recent evidence from the United States suggests that Donald Trump’s rhetoric in favour of tariffs on national security grounds was politically rewarding even as it imposed economic costs.

In conclusion, the relationship between trade and geopolitics has reached new levels of complexity. Economists and policymakers are faced with the challenge of sorting out the different forces that drive policy priorities, ensuring that the right policies target the right objectives, and presenting evidence that ensures that they are scrutinised. But to do all this, they will need to do more than produce numbers: they will need to develop a compelling narrative that reminds nations of the truths we have learned in the past - at great expense and sorrow. Namely, that global problems require cooperative, multilateral solutions, and that rivalrous behaviour leaves everyone worse off.

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In this blog Amar Breckenridge has provided a written summary of his speaking points from the panel on 'Economic security and the geo-politicisation of trade' at our UK Trade Policy Forum 2024.

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