Europe and the Global Economic Order
International trade has brought much prosperity to the world, but it is ironically the biggest profiteers who are hostile to free trade today. In the new era of geostrategic rivalry, the EU risks losing out if it does not develop further.
Why do countries voluntarily forego parts of their national sovereignty and subject themselves to international rules and institutions? Clearly, there are benefits from doing so: international cooperation allows a deep division of labour which, in turn, is a crucial determinant of general economic progress. But straight-forward observation shows that cooperation has limits: national borders persist and nation states have well-defined extensions.
The example of European Integration
To illustrate the economic logic governing international integration of markets and institutions, it is useful to consider Europe, still by far the world’s most integrated transnational economic space.
Europe has been built around the idea that its members share a set of fundamental beliefs about the appropriate social and economic order. Only because of this common ground have countries been able to create a single market, even a common currency, and the institutions that govern them. Since the beginnings, many thinkers expected that the national belief systems would converge, gradually giving rise of a distinctive European model. The creation of the Monetary Union is the best example for this hope. However, as Brunnermaier, James and Landau (2016) have quite convincingly shown that Europe is still in the middle of a battle of ideas, often along national lines, and that a common way of European thinking is emerging only very slowly. The lack of convergence of ideas is a problem: the more countries differ with respect to their preferences, the more any common set of rules, imposed by some central entity (Brussels) will deviate from the ideal representation of national preferences.
A common way of thinking, however, is not enough to cement a common economic and political institutional framework. Even with common set of shared beliefs, interests can diverge. European countries differ with respect to their grown institutions, patterns of comparative advantage and geography. Thus, economic theory quite straightforwardly suggests that the gains from trade differ across countries: small, central countries with comparative advantage in manufacturing benefit more from European integration than larger, peripheral, services oriented members. Felbermayr et al. (2017) make this point in a modern quantitative simulation model for Europe. Britain, it turns out, has benefitted the least from the EU. The reason is that it has relatively low trade costs with countries outside the EU (e.g., because of low language barriers), it own market is the second largest amongst EU members, and its pattern of comparative advantage implies net exports in the services sectors where the European Single Market is relatively underdeveloped. Hence, the benefits of membership to the EU are lower in the UK than elsewhere.
On top of this, one has to account for heterogeneous preferences, as argued above. But even if countries had perfectly identical preferences, giving away national sovereignty to increase the gains from international market integration comes with a cost: countries that can always be hit by idiosyncratic shocks rationally value the possibility to fine-tune rules as they see fit. Thus, whether or not to participate in the EU project depends on a trade-off: as long as the gains from further integration outweigh the costs, push ahead; but when the pros no longer outweigh the cons, stop. And, when circumstances change, countries might want to reconsider.
Such a framework can help to identify the borders of a deep European integration project. Moreover, at the global scale, the framework can help explain why some countries are much more inclined to give away national sovereignty to international organizations such as the World Trade Organization than others. Also, it appears that lessons learnt in Europe can serve in redesigning global governance structures. Most importantly, the European experience suggests that a very complex world probably requires a multi-layered institutional framework such as the one Europe has developed and needs to develop further.
The World Trade Organization at 25
On January 1st 1995 the World Trade Organization (WTO) came into existence. It is the result of negotiations during the so called Uruguay Round which started in 1986 and took place until 1993. In the middle of this period, Soviet-style communism collapsed in Europe. At that time, the attitude was wide-spread that the Western model of liberal democracies and market economies had won over alternative systems. In 1992, Francis Fukuyama published his famous book entitled “The End of History and the New Man”, expressing the idea that geostrategic rivalry has come to an end and that the future would be one of a single system rather than of systems competition. The WTO extended the Generalized Agreement on Tariffs and Trade (GATT), which had developed from 1948 onwards, and included provisions on services trade (the Generalized Agreement on Trade in Services, GATS) and on the protection of intellectual property. Quite importantly, in contrast to the GATT, the WTO has been endowed with an elaborate dispute settlement system.
In many ways, the WTO has been a success story: its membership has grown from 128 essentially non-communist GATT members to 164 countries to include former system rivals such as China, Russia, Vietnam and, of course, almost all formerly communist countries of Europe. It has overseen a period of spectacular expansion of world trade.
However, it has run into an existential crisis. Its appellate body, the appeal “court” of the multilateral system, is no longer functional since, starting under the Obama Administration, the US have refused to confirm the nomination of new judges. The WTO has not been able to conclude any large round of trade negotiations that would bring about a modernization of rules to cover, e.g., digital trade. It has been increasingly made obsolete as an ever-larger share of world trade is covered by preferential trade agreements outside of the WTO.
The WTO suffers from the fact that it has grown very large: it has 164 members which have very different economic size, very different levels of development, and very different political systems. Establishing, maintaining, modernizing, and enforcing a uniform body of rules for such a heterogeneous collection is obviously challenging. As in the EU, different members benefit to very different degrees from the the system, and they value the cost of foregoing an unconstrained trade policy quite differently. This suggests that, as Europe, the world needs a multi-layered system that offers different models of integration: a deeper one for core members, and a shallower one for the periphery – where periphery is defined in terms of countries’ willingness and ability to commit to common rules.
End of history, no longer
The fundamental issue with the WTO is that the end-of-history assumption of the early 1990s is no longer tenable. The period of hyperglobalization (Rodrik, 2011), that started in 1990s and endured until 2008, brought about a process of economic convergence by which emerging markets quickly caught up to Western economies, but it has not generated the convergence of political systems that many had hoped for. For example, very quickly after the accession of China to the WTO in November 2001, China slowed down and later stopped the process of opening up. When, in 2009, the Western World plunged into the deepest recession since World War II, China largely avoided a crisis. Consequently, the belief in the superiority of its system, summarized by the Washington Consensus, was shattered while the process of economic convergence quickened dramatically.
Today, the world seems back to a situation of systems competition, where the Western model is challenged by a Chinese alternative that follows not only a different development model but a very different philosophy about the relationship between state and economy. What is more, the largest “Western” economy, the US, is in the process of being overtaking in size by its “Eastern” rival.
The problem is that the WTO has not been designed for such an environment. Its central tenet is that all its members have the same fundamental objective, i.e., to maximize per capita income of their citizens. Under this assumption, the WTO’s principles of reciprocity and non-discrimination can be shown to yield a stable cooperative equilibrium, despite the short-run temptation of beggar-thy-neighbour policies (Bagwell and Staiger, 2002). Cooperation generates welfare gains everywhere. In the absence of geostrategic rivalry, it does not matter that the gains are distributed unevenly, typically in favour of poorer countries.
But when geostrategic competition enters the picture, countries increasingly care about the size of their own economies relative to their rivals’. This would be irrelevant in end-of-history thinking. Unfortunately, the Bagwell-Staiger results no longer hold in the presence of geostrategic considerations: reciprocity and non-discrimination no longer yield the right incentives for countries to foreswear the use tariffs and non-cooperative trade policies. Rather they may use trade policy instruments to keep geostrategic rivals at bay. In other words, the WTO and the GATT were designed to bring about cooperative outcomes in positive-sum games. This worked well between 1948 and 1990, when the system applied almost exclusively to US allies with the Soviet Union and its satellites excluded, and for the first years thereafter, where the end-of-history thinking prevailed. But the WTO and GATT rules have difficulties to work when countries fear domination and abuse by others. Such a configuration is inherently zero-sum in nature. In economic history, times of system competition are associated with block building and the weaponization of tariffs (Irwin, 2008).
The founding father of modern economics, Adam Smith, already described this problem in his 1776 opus magnus “The Wealth or Nations”. After praising the advantages of an international division of labor and after warning against the economic costs of beggar-thy-neighbour policies, in Book IV, he defends the Navigation Acts – a set of policies that had the objective of keeping out Dutch sailors from British harbors using the famous formulation „…defence, however, is of much more importance than opulence“ (Book IV, Chapter II, p. 465). The Dutch were seen as geostrategic rivals by the British that could not be trusted: the expectation was that they would recklessly exploit British competitors if they were allowed to dominate the global maritime trade links. Without deep trust, that a deep global division of labor does not lead to exploitation by a trade partner whenever it has the opportunity, such security concerns appear of vital national interest.
Indeed, the GATT contains a national security exception in its Article XXI, and Section 232 in the US Trade Expansion Act of 1962 enables the US president to impose tariffs on imports that threaten national security. In March 2018, citing these legal texts, the US imposed tariffs on steel and aluminum products, including on exports from NATO allies such as the UK or Germany. In this special case, it is very hard to defend the US argument, but the existence of those instruments both in international and in US law shows that Smith’s qualification has always been important for law makers.
In contrast, economists, at least in mainstream thinking, have tended to ignore these considerations, probably for both positive and normative reasons: First, the world economy of the Post-World-War II period was so clearly dominated by the US that one could safely design optimal institutions within the given power system and ignore security considerations. Second, economists were understandably reluctant to advocate aggressive policies that would harm the world economy. As a consequence, political security considerations are almost fully absent in the economic analysis of commercial policy (for example, see the chapters in the Handbook of Commercial Policy (Bagwell and Staiger, eds., 2016).
War by other means
Political thinkers have been less reluctant. Blackwell and Harris, in their 2016 book, show how a large, technologically advanced country such as the US can successfully engage in “War by Other Means”. In such a context, the success of commercial policies is not (only) measured by their consequences on per capita income but also and maybe predominantly by their effects on one country’s GDP relative to the other’s.
To understand the present condition of the global trading system one has to account for the geostrategic picture. Even before the current US president came to power, the US was working on strategies to contain the economic raise of China. The Transpacific Partnership (TPP) agreement designed by foreign secretary Clinton had the purpose to marginalize China; studies predicting its economic consequences show this quite clearly, see, e.g., Aichele and Felbermayr (2015). The current US Administration very explicitly uses trade policy tools to slow down economic progress in China. Indeed, most empirical studies of the ongoing trade conflict suggest that the economic damage of the mutual imposition of tariffs is at least three times larger in absolute terms in China than in the US. So, when the US president Trump tweets that trade wars are good and easy to win (tweet by @realDonaldTrump from March 2, 2018), he might be right if success is measured in a zero-sum game in which the party wins that inflicts the larger economic costs on its rival.
A risky strategy
But trade wars do generate economic damage, on both sides of the conflict, and for the world economy in total. And the danger of economic damage extends beyond tariffs. Since 2009, the use of other measures aiming at protecting markets against foreign competition has gone up systematically. Evenett and Fritz (2019) document the rise of non-tariff measures over the last ten years. In many ways, they are worse than tariffs. First, they are much less transparent – their costs are less obvious as they are often cleverly disguised as legitimate regulation; second, they do not generate tariff income but impose extra expenditure, often wasteful ones, on trade partners; third, the international rules offer fewer ways of dealing with them. Examples are easily found in procurement regulation such as the Buy-American-Act, competition law, taxation, and even in fiscal stimulus programs such as cash for clunkers.
While their economic costs are higher than tariffs, non-tariff measures can also be used to pursue geostrategic objectives. Finally, uncertainty about the conditions of market access can be used strategically as well. The threat of a tariff might be enough to induce foreign producers to serve a large market by local production rather than by exports. More generally, in an increasingly uncertain world, large economies tend to appear as safe havens. So, such countries may have incentives to generate uncertainty.
Clearly, such strategies are very risky. Economic history teaches important lessons. After, under the 1929 Smoot-Hawley-Act, the US had imposed high tariffs on trade partners and other countries had reciprocated, world trade spiralled from US$5.3 billion to only a US$1.8 bn in 1933. Economic historians largely agree that those tariffs have not caused the Great Recession but have prolonged it, thereby paving the way to the atrocities of World War II.
As a consequence of the return of trade restrictions, international trade growth has slowed down. Trade is still expanding as the world economic grows, but its growth rate relative to that of total production has declined. During the era of hyperglobalization, trade in goods expanded much faster than industrial production: countries imported an increasing share of domestic demand and exported an increasing share of domestic production. Since approximately the year 2008, goods trade no longer outperforms production; the process of globalization has come to a stop.
The OECD Trade in Value Added Statistics show that since about 2010 global value chains have started shortening in many countries, most strongly in China. In 2000, one dollar worth of Chinese exports contained 40 cents of foreign value added in the form of foreign inputs; in 2015, that share has fallen to 17 cents.
It is still debated to what extent the rise of protectionism since 2009 relative to other forces such as a fundamental change in the Chinese growth model has contributed to this phenomenon that the British magazine The Economist has called “Slowbalization”. It is also unclear, how the situation outside of goods trade, which still dominates international trade statistics, has evolved. International services transactions and data flows continue to grow, but there are severe measurement issues and the performance of international transactions relative to domestic ones is not straightforward to ascertain.
Having said this, technological change is likely to have important effects on the integration of the world economy. Actually, over the last 70 years, technological changes such as the introduction of containerization or the digitalization of the supply chain have had stronger effects on the growth of trade relative to domestic transactions than policy has. Hence, it is probably safe to assume that further innovations, such as artificial intelligence, will lead to a further reduction of trade costs, for example the need for expensive language translation. For this reason, Richard Baldwin (2019) expects a new wave of globalization that might go deeper into the fabric of national labor markets than former waves. At the same time, new technologies might lead to reshoring of production from labor-rich emerging markets back to capital-rich richer ones.
What is to be done: Five ideas for the new EU Commission
Despite these uncertainties, for the reasons sketched at the beginning of this chapter, it is clear that slowbalization is more painful for some countries than for others. Germany, for instance, is more vulnerable than any other industrialized country with a similarly sized domestic market (here, it is important to distinguish between Germany as a country with immobile citizens, and German firms which might be active in many countries and therefore able to hedge against trade policy uncertainty). Europe, as a whole, also appears more vulnerable than either the US or China. On top of this, the EU has no offensive geostrategic interests such as the US or China, but still risks being drawn into their conflict. It is all too easily imaginable that a US administration asks for European fellowship in its conflict with China, leaving the old continent an extremely difficult choice between losing either the US or the Chinese market while maintaining the other.
For the new European Commission under its president Ursula von der Leyen, there are five points of strategic importance that emerge from the analysis conducted above.
First and foremost, in a world of new geostrategic rivalry and systems competition, where key players are driven by zero-sum reasoning, Europe must ask itself what its own interests are and how it can defend it. To start with, it is of paramount importance to recognize that the global order has changed and will not return to the friendly ecosystem led by the US from after World War II to, say, 2006, that was so conducive to the construction of the European project. The European project always had the objective to promote European economic sovereignty: the Customs Union, the Single Market, the Monetary Union all exist because the EU members are much better able to defend their interests in a coalition than they could each on their own. This is why they have given up an independent trade policy, regulatory autonomy, and their own currencies.
In the new era of geostrategic rivalry, the EU risks losing out if it does not develop further. In particular, it needs to define an appropriate concept of economic sovereignty, and develop its related objectives and instruments. The historical focus of the EU on economics rather than on security and national defence needs to be reconsidered, but without naïveté: in this context, as with economic integration, benefits need to outweigh costs, and the latter tend to be larger in the multi-country European Union than in any classical nation state. This means, that, first, economics will continue to play a pivotal role, and, second, the EU needs to learn how to use its economic clout to achieve its strategic goals.
The danger, of course, is that, under the pretext of defending its economic sovereignty, the EU turns towards downright protectionism. Therefore, any sharpened or newly developed instruments, such as for example the EU investment screening regulation, must come with mechanisms that insulate them against protectionist abuse. Any new instrument must be generalizable to a desirable multilateral order – which, however, cannot mean that it must necessarily comply with the WTO, the 25 years old institution developed, as explained above, under the now defunct end-of-history paradigm. Whenever possible, the EU should proceed with like-minded allies, with whom free trade agreements exist or in the process of being concluded, such as Canada, Japan, Korea, Australia and so forth. Also, the EU should avoid new illusions such as the idea that the diffusion of technology could be blocked. We live in a globalized world and, even with new political barriers, the flow of ideas will continue.
Second, and central to developing a strategy to defend its economic sovereignty, the EU must do whatever it can to defend and further deepen its Single Market. It is by far the most valuable ingredient of the EU integration project: 75 percent or more of the welfare gains from the EU come from it; see Felbermayr et al. (2018). The Single Market is the best possible insurance device: when the international order crumbles and new uncertainties build up, it serves as a safe haven for European producers, consumers, and workers. It increases the gains that member states have of being in the EU and therefore reduces centrifugal forces. Access to it is the most important asset that the EU has to bargain with in international negotiations. A deep and successful Single Market gives the EU external clout. For these reasons, the EU must prioritize the establishment of a common digital market, common energy and electricity marketa, the development of adequate infrastructure to undergird those ambitions, and the willingness to further develop transnational transportation links. It also must repair the Schengen Zone and end border controls within it. Survey evidence put forward by various sources (e.g., DIHK 2019) shows that frictions in the Single Market have increased, not fallen, therefore compromising the EU’s strategic interests.
The withdrawal of Britain from the EU is, of course, a big blow to the EU’s international influence. The Brexit reduces the size of the Single Market by as much as the exit of the 19 smallest EU members would. Therefore, Europe must work out models that tie countries at the European periphery – such as Britain after Brexit, or Turkey, or Switzerland – to the Single Market as strongly as possible. Crucially, Europe should offer countries, which are not in the European Union proper, to enter into a Customs Association with it. While such an agreement would not go as deep as the EU Single Market, it could fully cover goods markets. At least in this area, then, the EU would maintain or even extend its international reach.
The third area of importance to defend economic sovereignty relates to the currency union. In many countries, the Euro is almost exclusively seen as a monetary policy project. As a consequence, the discussion is almost always about flows of credits between central banks (target balances), interest rates, or quantitative easing. Sometimes, trade economists stress that the Euro is also about transaction costs. They show that the introduction of the Euro has indeed fostered trade between its members (Felbermayr and Steininger, 2019).
The Euro is, however, too rarely thought of as a geostrategic tool. This could mean to strike compromises in the area of monetary policy. For example, to increase the Euro’s role as an international reserve currency, a sufficiently large supply of safe Euro denominated bonds is of paramount importance. This could be achieved by creating European Safe Bonds (Esbies).
The fourth area of action is international trade policy. The WTO as the corner stone of the multilateral order is in an existential crisis. As explained above, that crisis relates to very fundamental issues arising from systems competition that will not go away any time soon. For this reason, the EU needs to develop a plan B. It has already concluded an agreement with Canada about a substitute to the appellate body; it needs to develop this further and extend it to as many countries as possible. More generally, Europe needs to prepare for a world, in which the WTO takes even more damage that it already has. For example, Article XXI, which allows members to cite national security concerns to suspend trade concessions, is already more widely applied, substantially increasing trade policy uncertainty around the world. Europe needs to do more to defend the key elements of the multilateral order, and, if needed, apply more pressure.
This, however, requires credibility. Europe must move beyond paying lip service. It has followed Trump's steel tariffs by imposing its own steel tariffs against third countries such as Brazil, Turkey, or South Korea, in order to avoid their steel products to be redirected to Europe. I think this is a mistake. We need a club of the willing – countries who want to protect WTO. The WTO has 164 members. The US is one, China is another, but there are 162 more. Many of them are looking for leadership. Europe should provide this leadership – who else could? – and play a constructive role in modernising the WTO, in making it greener and more flexible, but without pretending to maintain a single uniform model that works uniformly for all countries.
Finally, Europe has to be more confident of the value of bilateral trade agreements. True, a global set of rules is preferable to bilateral agreements which tend to generate harmful trade diversion and fragment the trading system. But if the global system is breaking down, and legal certainty is becoming weaker, bilateral agreements are welcome remedies. Therefore, Europe needs to develop additional and deeper bilateral trade agreements that cover more countries and more areas. Again, compromises will be needed. For example, the Mercosur agreement or those with ASEAN country do come with the risk of generating inconsistencies in the area of environmental policy, but safeguarding transparency and legal order in an increasingly disorderly global trading system would be a very important achievement indeed.
The text is the basis of Gabriel Felbermayr's inaugural lecture on 22nd January 2020 at the CAU in Kiel.
© The Standing of Europe in the New Imperial World Order – Corinne Michaela Flick (ed.) – CONVOCO! Editions
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Coverfoto: Dimitris Vetsikas on Pixabay
The Kiel Focus series presents papers on current economic policy topics. Their authors are solely responsible for their content and their views or any policy recommendations they may make do not necessarily represent the views or recommendations of the Institute.