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Jan 04, 2023

How Europe Can Shape Changes in the World Economy

The frenetic growth of world trade has been over for some time. Geopolitical risks are now leading to a new order. This by no means heralds a phase of deglobalization—which is empirically unlikely and would be costly economically. The European Union would do well, however, to ensure greater diversification.

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US Secretary of State Antony Blinken, US Secretary of Commerce Gina Raimondo and European Commission Executive Vice-President Margrethe Vestager participate in a US-EU Stakeholder Dialogue during the Trade and Technology Council (TTC) Ministerial Meeting at the University of Maryland in College Park, Maryland, US, December 5, 2022.
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The era of hyperglobalization (Dani Rodrik) is over. But this turning point did not take place when Donald Trump became the 45th US president or when Russia attacked Ukraine. The trend shifted around the time of the economic and financial crisis of 2008-09. From 1970 to 2008, the ratio of the sum of all countries’ exports of goods and services to the world’s GDP grew from about 13 percent to 31 percent. Since then, this measure of globalization has been moving sideways rather than upward. The same is true for trade in goods and global industrial production.

In short, world trade is growing at about the same rate as world output. This is not a situation of deglobalization; on the contrary, trade volumes continue to grow. At present, price-adjusted global goods exports are around 36 percent higher than in 2008, with those of the eurozone up by 17 percent. Deglobalization looks different. Rather, as the British weekly magazine The Economist put it in January 2019, we are dealing with a “slowbalization.”

Neither does the rapid recovery of world trade after the slump in the wake of the COVID-19 crisis support the deglobalization thesis. The level of global trade in goods, adjusted for prices is, in September 2022, about 10 percent higher than the average for the pre-crisis year 2019. It is also slightly higher than the level before the start of Russia’s war against Ukraine. Global trade has proven surprisingly resilient, despite all the prophecies of doom.

A permanent state of hyperglobalization would also not be consistent with the commonly used economic models of world trade. These share the prediction that—if nothing else changes—world trade should grow at roughly the same rate as world output. Thus, the current situation of sideways movement would be the “normal” condition, while the phase of hyperglobalization would be an exception. World trade grows faster than global GDP only under certain conditions. Under normal circumstances, the degree of openness of the world economy should be stable. In this respect, hyperglobalization was a rather exceptional phase.

Indeed, some of the special factors behind hyperglobalization have weakened over the past 15 years. The World Trade Organization (WTO) did not bring the Doha Round to a conclusion and has not had fully functioning dispute settlement bodies for several years. Since 2008, the number of new bilateral free trade agreements has been steadily declining. Planned “mega-regional” agreements such as the transatlantic free trade agreement TTIP failed.

But the technological drivers of globalization are not standing still. Digitization is lowering the costs of international transactions, for example through automatic language translation, unbureaucratic and secure processing of transactions via blockchain, or digital procurement platforms. Above all, services that were previously not considered internationally tradable can increasingly be purchased and provided across borders. The available data, however, do not allow a clear picture of the structure and dynamics of trade in services. For example, US tech companies market their services in Europe via countries with low taxes, so that service imports from the US are underestimated. Instead, high US primary incomes are generated in Ireland, for example, which are not even recorded in the trade balance. For an integrated view of the state of globalization, therefore, the balance of payments should be considered, where trade in goods and services as well as cross-border income are shown.

Higher Dynamics in Services

This view is informative in several respects. First, trade in services and primary income show higher dynamics than trade in goods. Second, economic dependencies also look different. While China is the most important supplier of goods to the EU, it exports hardly any services and generates little primary income there. On the import side, the US is still the EU’s most important economic partner, and the United Kingdom and China are roughly on a par. On the export side, the picture is even clearer; here China is well down in third place, only slightly ahead of Switzerland.

In view of technological developments, the services sector is expected to remain highly dynamic. In addition, increasing uncertainties in trade in goods, for example due to implicit or explicit threats of new tariffs, are leading to higher direct investment because foreign markets are being served more by local production and less by exports from Europe. Globalized business models thus change their form, but they remain in place. In the statistics, however, they no longer appear in the trade data, but in the balance of payments. Of course, political barriers that bring about comprehensive decoupling could still be erected. However, this would be neither desirable nor do the current empirical findings point in this direction.

Transformation, not Reduction

The lessons learned from the various crises since 2008 amount to greater diversification of procurement and sales markets. This by no means results in a permanent reduction in cross-border trade, but rather in a transformation: if, for example, fewer goods are purchased from China, imports from Vietnam or Indonesia increase. Imports as a whole do not decline. This is very evident as a result of US President Donald Trump’s punitive tariffs on goods from China. The formation of economic blocs, such as a transatlantic alliance or a Southeast Asian one, need not lead to deglobalization at all. Trade flows will be reordered without a decline in the volume of cross-border trade. This is very likely, if only because in many advanced economies the resources for increased local production of previously imported goods or services are not available, so that a shift back would have high net economic costs. .

Europe’s various current challenges point more to deepening globalization than to the opposite. Demographic change will make it necessary for the old continent to specialize even more in capital-intensive sectors and import labor-intensive goods and services. A green transformation that is not to endanger the level of prosperity will require high productivity advances: more output from a smaller input of resources. This will hardly succeed without wise use of the international division of labor. In addition, effective containment of current high inflation clearly requires more international competition, not less.

Relations with China

So, globalization is changing, but it is not diminishing. This transformation is well illustrated by two case studies: relations with China and the transformation of energy flows.

As things stand, the EU and China maintain close trade relations, which have expanded considerably in recent years—hardly surprising given the strong above-average economic growth in the People’s Republic. In 2021, for example, EU imports of goods from China were 22.8 percent higher than in the previous year and exports of goods 10.2 percent higher; in a ten-year comparison, the increases were as high as 84.4 and 76.4 percent respectively. So, in goods trade, there are no signs of an absolute decoupling with China, even though Chinese GDP (calculated in US dollars) grew even more strongly (namely by 134 percent) from 2011 to 2021. The findings are very similar for China-US trade. However, a different trend is emerging in terms of foreign direct investment from China to the EU: in 2021, Chinese FDI reached its lowest level since 2013 at €10.6 billion. Nevertheless, China remains one of the EU’s most important investment partners. Overall, China contributes to Western economic growth and prosperity.

Still, it must be made clear: sticking with the status quo is not an option. For one thing, China’s economic growth prospects are probably lower than previously assumed and future Chinese economic performance is increasingly unclear. For another, major geopolitical risks, e.g. from a Taiwan conflict, must be better taken into account.

Since China’s economic growth has slowed, Beijing has been publishing less and less economic data, and what is published is often of questionable quality. For example, according to the Financial Times, the number of economic indicators published by China’s Bureau of Statistics has declined by nearly 75 percent. The lack of Chinese transparency on economic performance leaves many unanswered questions about the state of the Chinese economy and its growth prospects.

A Darkening Outlook

A study by Luis Martinez measures economic growth using data on nighttime light intensity from satellite imagery, an established proxy variable for determining economic performance; the brighter a country is lit at night, the greater its GDP. In his study, he discovered  a large discrepancy between official growth figures and estimated GDP based on light intensity in autocratic states in particular. China is no exception here. Martinez speculates that annual Chinese economic growth is to be estimated as, on average, one third lower than the official Chinese figures would like it to be believed. In this case, in purchasing power parity terms, the Chinese economy would be significantly smaller than that of the US and not larger, as is officially claimed.

The economic basis for more trade with China is thus dwindling, while system rivalry is intensifying. On the one hand, the latter is due to China’s domestic policy, which is becoming increasingly repressive. On the other hand, China is also acting more and more aggressively in foreign policy and against Western interests. The hope that China would draw closer to our economic system through close economic cooperation has turned out to be deceptive. This is leading to tensions in the world trading system, which the EU is countering with its own instruments.

The slowdown in China’s innovation process also shows that the Chinese approach with dirigisme from above has limits. Daron Acemoglu of the Massachusetts Institute of Technology (MIT) has shown in a recent study that the politicization of faculties in Chinese universities leads to a weakening of research and patent performance. China’s “dual circulation” strategy is an attempt by China to reduce dependencies and be independent of the West in key fields of technology. At the same time, China is actively seeking to obtain Western technologies. It is thus beyond doubtful that a strongly dirigiste innovation system will win the global innovation race. China’s economic outlook is, therefore, overestimated in our assessment.

Reevaluating Risk

However, the economic relationship with China must also be reevaluated from a geopolitical risk perspective. According to a report in the Financial Times, the US expects annual global economic losses of $2.5 trillion in the event of a Chinese blockade of Taiwan. This would be a massive economic shock and is seen as a US warning signal that holding on to China as a close trading partner is risky. It is difficult to assess the likelihood of a military confrontation, but the costs are so high that they should be factored into all business decisions regarding Taiwan and China.

What should be clear is that a direct military confrontation would lead to Western companies having to massively reduce their relations with China as a matter of principle. This does not mean doing so today. It does mean, however, that companies must take this risk seriously and develop entrepreneurial strategies now in order to be able to continue operating in such a dramatic situation despite high losses.

The message here is not that globalization is in decline due to the Chinese economic system and geopolitical risks. It is, rather, that companies are looking to diversify their supply chains and enter other markets. Such diversification would make the economic system and supply chains more resilient to geopolitical shocks and create new growth advantages. The example of China shows a transformation of globalization away from a strong focus on China to a broader range of trading partners.

Transformation of Energy Flows

The green transformation of the economy will also change global energy flows. In order to counteract advancing climate change, the EU wants to almost completely phase out fossil fuels in the next 30 years with its Green Deal. Since these fuels are largely imported, one of the world’s most important importers of oil and gas would be eliminated from the global market over the next few decades. This is likely to have an impact on world market prices and, of course, on fossil fuel suppliers. Already today it can be seen that important countries in the Middle East are turning more toward China, as the United States is now no longer a net importer of oil, and Europe is losing importance more quickly in the medium term. At the same time, however, a global market for green energy will emerge where Europe will act as a net importer earlier and more strongly than its competitors.

The impact of climate policy on Russia has now been eclipsed by energy sanctions. Long discussions in the EU about possible energy sanctions led to increased prices while export volumes from Russia to Europe remained unchanged. This problem was further exacerbated when Russian President Vladimir Putin turned the tables and sanctioned the EU with a significant curtailment of pipeline gas exports. By almost completely cutting off gas supplies to Europe, Russia not only reduced the global supply of gas, but also made gas scarcer and more expensive, especially in Europe.

In the short term, these developments are again transforming globalization. Liquefied natural gas imports, as well as increased imports from Norway, have replaced Russian gas in Europe, while raising global prices. The consequences of these price developments are also being felt very concretely by the EU, which after years of trade surpluses is running a trade deficit for the first time in over ten years. In addition to this shift in energy imports, imports of Chinese solar panels also doubled in the first half of this year.

In the medium and long term, more expensive prices for gas and oil in Europe are likely to accelerate the decarbonization of Europe. This is changing energy flows and leading to new flows of goods, e.g. in the field of renewable energy.

Diverging Approaches to Climate Protection

The increasingly divergent approaches to climate protection are likely to be more serious for globalization, however. On the one hand, there is the subsidy-based approach currently being pursued by the US and China. China has been massively supporting its green industries with official funds for some time. The US has now followed suit with the Inflation Reduction Act, announcing $369 billion in investments in green transformation and energy security over the next ten years.

Europe is pursuing a different approach, namely to achieve its climate targets primarily through higher prices for emissions. With the Emission Trading System, emissions are, in effect, taxed. There is thus a risk that energy-intensive industrial production will move out of Europe, not only because of expensive gas prices but also because of higher taxation, without significantly reducing global emissions. These different approaches to climate protection will lead to tensions in world trade. Measures such as a CO2 border adjustment (CBAM) can be designed to be WTO-compatible and can compensate for the distortions caused by the different approaches, but they will nevertheless lead to political tensions. The hope that a climate club could be established, especially in Germany, is visibly being dashed.

Recommended Actions for Europe and Germany

The global economy is changing, perhaps faster than usual at the moment. Contrary to widely held opinions, however, there is no de-globalization, but rather a transformation of the world economy. This is easily explained. Integration into the world economic system continues to bring numerous benefits for states, companies, households, and employees. The example of the United Kingdom in particular illustrates how costly it is to turn away from one’s most important trading partner. Brexit also shows that distribution problems are not solved by reducing trade relations.

However, the transformation of the global economy, in the area of trade in services, in trade relations with China, and in the area of energy flows, also creates new challenges that should be tackled. Germany should use its influence through the EU, which has sole competence in the area of international trade and foreign direct investment, to shape meaningful rules for the changing global economy. The fundamental goal should remain a rules-based, multilateral economic order, so that world trade is subject to clear rules; less large and powerful states should be able participate in the world trading system.

The pressure exerted on the world economic order by non-democratic states with strongly divergent economic systems must be countered intelligently. This requires an integrated approach that strategically combines foreign economic and security policy.

The attractiveness of the EU’s single market remains the most effective tool for promoting incentives for cooperative behavior by other states. The simple reason is that all enforcement mechanisms are based on denying access to this single market; the larger, deeper, and more dynamic this market is, the greater the chances that the EU and its members can continue to shape the global economic and political order in their interest.

Nevertheless, instruments for defending and asserting interests must be further sharpened. A strong and resilient macroeconomy and a strong international role for the euro are crucial for a successful foreign economic policy. Only in this way can Europe and Germany permanently resist the increasing economic pressure from other, especially autocratic, states.

In climate and energy policy, decarbonization must be driven forward at full speed. It is up to Europe to take a leading role in this. In this context, competition between different systems will also increase the pressure in Europe to rely more on state-supported innovation. The cheapening of green technology thanks to innovation offers the opportunity to accelerate decarbonization worldwide and, at the same time, to also achieve new corporate and product leadership from Europe. Decarbonization must be accelerated worldwide, and it is up to the EU and Germany to create sufficient incentives and pressure for as many countries as possible to follow suit.

Systemic conflict between the US and China, which is playing out particularly strongly in the technology sector, will shape European foreign economic policy in the coming years. This is a clash between two of Europe’s most important trading partners. Europe’s interests are therefore far too strongly affected for Europe to be a neutral observer. For all its existing differences with the US, Europe is much more closely tied to the US on systemic issues, as another democracy, than it is to China. Therefore, the goal of European policy must be to reduce technological vulnerability to China and manage interdependence. In the area of data management and data confidentiality, as well as the regulation of large platforms, Europe plays a leading role and should use this especially vis-à-vis the US.

Even if the world economy is facing some drastic changes, the end of the age of globalization need not be heralded. Germany and Europe will continue to be relevant players in the global economy in the future. In order to manage these changes successfully and enable globalization to continue, Germany and the EU must consider foreign economic policy in a more strategic and integral manner. Then it will be possible to shape the upcoming transformations of globalization in the interest of Europe. After all, globalization will continue to be in the interest of Europe and Germany in the future.

Gabriel Felbermayr is Director of the Austrian Institute of Economic Research and Professor at the Vienna University of Economics and Business.

Guntram Wolff is Director of the German Council on Foreign Relations (DGAP).

The authors thank Ole Spillner for his assistance with research.