Europe in a Fragmented World

November 30, 2023

Berlin, Germany

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Good afternoon. It is a pleasure to join you today.

Let me begin by thanking Moritz and Sebnem for the very kind introduction. Sebnem is a phenomenal researcher and dear friend from whom I have learned a lot. I am extremely thankful for her generous words.

I would also like to thank the Kiel Institute for the Bernhard Harms Prize. I am honored to receive a prize that champions scholarship in international economics and global relations.

Such scholarship is critically important at a time when countries are drifting further apart. The Covid-19 pandemic and Russia’s war in Ukraine have heightened concerns about the risks inherent in a deeply interdependent world. The pandemic disrupted supply chains and led to shortages and price surges, raising questions about the reliability of global trade. The war triggered a severe energy crisis and exposed vulnerabilities in interdependence. Meanwhile, tensions are growing between the two largest economies in the world: the US and China.

In this environment, global economic relations are now increasingly dictated by security considerations: security of supply chains and security of nations. It is understandable that policymakers must give resilience greater consideration in their decision-making. But the wrong policies could severely damage prosperity and actually weaken security.

In my lecture on “Europe in a Fragmented World,” I will make three broad points based on research we have just released today. The first is that geoeconomic fragmentation is increasingly a reality. Since the start of the war in Ukraine, trade within a politically aligned bloc of countries has grown nearly 1½ percentage points faster than trade across blocs. The second is that the European Union is uniquely exposed to fragmentation, yet uniquely prepared to deal with it.  The EU’s large and diverse membership of advanced and emerging market countries provides the scope and scale to support European-based supply chains. The third is that to leverage the unique features of the EU, a singular focus of EU policy makers should be to deepen the single market alongside advocating for a rules-based global trading system.

#1 GEF is increasingly a reality.

Let’s begin with the increasing reality of geoeconomic fragmentation. The share of global trade in world GDP has been relatively stable. This may lead one to conclude that all this talk of fragmentation is much ado about nothing.

But that would be the incorrect conclusion. While overall trade as a share of GDP has not changed much, there have been meaningful shifts in underlying bilateral trading relations.

A stark example is Europe and energy. The EU’s overall external dependence on energy is little changed, but where it buys from has changed dramatically. Following Russia’s invasion of Ukraine, the EU reduced its direct imports of Russian gas from over 20 percent of total gas imports in 2020 to around 5 percent by the first half of 2023, while increasing its imports from the US and Norway by substantial amounts.

This reorganization, while clearly necessary, has come at a price. EU wholesale gas prices are now about twice as high as before Russia’s invasion and are considerably higher than those in the US.

Such reshaping of supply chains is a more general phenomenon. Growth of trade has slowed everywhere. Trade within a politically aligned bloc of countries has about halved from 3 percent pre-war. However, trade between blocs that are not politically aligned has slowed much more, declining from 4 percent pre-war to around 0%. On net, this generates 1.5 percentage point faster growth in trade within blocs as opposed to between blocs.

Supply chains also appear to be lengthening as trade is being re-routed through neighboring countries, often without changing the ultimate country of origin or ultimate destination.

Take Russia, for example. Exports from neighboring EU countries and Ukraine have dropped sharply—including by 75 percent for Finland and 100 percent for Ukraine—even as exports to Russia from several other neighboring countries—such as China and Kazakhstan—have more than doubled. They have even risen five-fold in the case of Armenia.

Evidence of a similar lengthening of supply chains due to the re-routing of trade through neighboring countries is also apparent for countries that neighbor China and the US.

There are also clear signs that global foreign direct investment (FDI) including by the EU—is segmenting along geopolitical lines. Over the last decade, the destination for global FDI is being increasingly driven by geopolitical closeness as compared to geographic closeness. This is particularly the case for FDI to strategic sectors or where the recipient country is an emerging market.

In the case of Europe, outward FDI by EU countries has become more responsive to geopolitical distance since 2017. In fact, fragmentation of outward FDI flows by the EU began soon after the euro area debt crisis. While extra-EU FDI to geopolitically aligned countries recovered strongly, the recovery to other countries was very weak, and flows have declined further since 2018.

The shifting pattern of trade and FDI comes not only from firms’ desires to build resilience but also from a sizeable increase in cross-border restrictions.

The number of measures that are harmful to trade has been growing and vastly exceeds liberalizing measures. So far this year, 750 liberalizing measures have been announced against almost 2,900 harmful measures—including subsidies to production and exports, as well as tariffs. This is close to triple the number of harmful measures announced in 2019.

Some of these policies directly target trade, while others are behind-the-border measures. This includes fiscal and financial support to specific sectors and local content requirements that benefit domestic industries.

The EU is not just a bystander: it is also imposing its own policies with particular reliance on financial support measures. The amount of approved state aid to private companies has grown from an average of 1 percent of member countries’ GDP in 2019 to 2.3 percent of GDP in 2021, with a wide dispersion across countries ranging from 0.7 percent of GDP in Ireland to 4.6 percent in Malta.

So clearly, geoeconomic fragmentation is a reality, and this impacts all countries, each differently. This leads me to my second point.

#2 Europe is uniquely exposed to fragmentation, yet uniquely prepared to deal with it.

The EU is highly open to trade, which makes it particularly vulnerable to trade disruptions. The share of extra-EU foreign trade to EU GDP at over 40 percent in 2021 exceeds that of the US and even China, despite being of roughly similar economic size.

The EU is also more open in terms of inward and outward FDI than other regions. The stock of non-EU FDI stood at more than 90 percent of GDP in 2021, considerably larger than for China and the US.

The EU’s direct dependence on countries that are not politically aligned with the EU—based on UN voting on the 2022 Ukraine Resolution—is also high. About 40 percent of imports from outside the EU are sourced from countries not aligned with the EU and around half of such imports would be difficult to access through alternative suppliers. This includes some natural resources essential to the green transition that tend to be concentrated geographically and some manufactured intermediates—such as advanced semiconductors—for which quick replacements are difficult.

The EU’s indirect dependence on countries it is not politically aligned with is even higher in some important instances. Take, for example, the EU’s reliance on China. China’s importance as the ultimate source of inputs into production and as a final market for EU-made products has continued to rise, including for manufacturing.

In the case of the EU-based auto sector, China provides 10 percent of the final value added and is the final market for 7 percent of EU-made cars. Both shares are more than double where they were a decade earlier.

This said, while the EU is particularly exposed to trade and FDI disruptions, it may also be particularly well placed to build resilience. The EU’s large and diverse membership of advanced and emerging market countries provides the scope and scale to support European-based supply chains.

The EU’s mix of innovation and manufacturing provides an ecosystem quite different from both the US, which is comparatively more specialized in innovation, and from China, which is more focused on manufacturing. Specifically, the EU encompasses countries where the equivalent of 7-9 percent of manufacturing value added is channeled back into research and development, for example the Nordics, Benelux, Germany, and France.

It also includes countries that undertake considerably more manufacturing, but less manufacturing R&D. Countries can therefore specialize in innovation or manufacturing according to their comparative advantage within the “level playing field” and low frictions guaranteed by the Single Market.

In principle, these attributes should allow the EU to better meet the pressures from geoeconomic fragmentation. If necessary, the EU is potentially better placed to re-shore global production to cost-efficient manufacturing locations with lower adjustment costs.

In practice, however, to realize the benefits of the Single Market, much bolder reforms will be needed. This leads me to my third point.

#3 A singular focus of EU policy makers should be to deepen the single market alongside strongly advocating for a rules-based global trading system.

As a major participant in world trade, the EU has benefited greatly from a multilateral rules-based system. In its external policies the EU should continue to be a strong advocate for openness and for the proper functioning of the WTO. This is not only for its own sake but also to ensure that emerging and developing countries beyond the EU have a firm foothold in the global trading system as a ladder to their own prosperity and economic resilience.

In this regard, the EU should ensure that its climate-related policies are compatible with WTO rules. That includes implementing the Carbon Border Adjustment Mechanism (CBAM) in a manner that encourages greener imports into the EU, thereby making clear to trading partners that the goal is to protect the planet rather than EU industry. To achieve that goal, to the extent possible, the CBAM should be based on actual emissions embedded in imports rather relying on EU industry benchmarks.

While staying within the global rules-based system, some reconfiguration of trade and FDI flows to protect economic security can make sense given the changed geopolitical landscape. The EU’s strategy to achieve this by “targeted de-risking,” rather than outright “decoupling,” is sensible.

Taking preemptive action to mitigate areas of high risk—such as through diversifying suppliers, holding inventories, improving recycling or, possibly, homeshoring for activities that matter for economic security—can be seen as pragmatic self-insurance that warrants the additional upfront economic cost.

Some medical products, or inputs needed to strengthen energy security, are examples of goods that may qualify. But the bar should be set high.

Deepening economic partnerships with countries that present less geoeconomic risk can also help. But this might be easier said than done.

Agreements with the US on metals tariffs and workarounds to the US Inflation Reduction Act are still pending. The EU has concluded free trade and partnership agreements with many countries around the world, but notably reaching new trade deals with some emerging market, resource-rich countries—such as Indonesia and the Mercosur region—has been slow.

Moving ahead may require the EU to find ways to protect environmental and labor standards while addressing partners’ concerns about their effects.

Developing long-term infrastructure partnerships, as the EU is seeking to do through its “Global Gateway” Initiative, could also build resilience. To be successful, related projects should be mutually beneficial and support development of the host-country’s economy so that the investments are financially sustainable.

In addition to advocating for the global rules-based trading system in its external policies, it is critical that the EU’s internal policies protect and deepen the Single Market. This would help leverage its unique ecosystem with its mix of innovation and manufacturing strengths to generate higher growth and build resilience.

There is ample room to strengthen intra-EU integration. Better harmonizing taxes and subsidies across countries would increase investment in cross-border infrastructure and discourage “state aid” shopping. It is critical to complete the capital markets union and banking union to help mobilize sufficient funding for EU’s enormous climate and digital investment needs and keep the EU globally competitive and at the technology forefront.

In a model of innovation and multinational offshore production, we find that lowering internal barriers within the EU would generate large welfare effects—on the order of 7 percent of GDP—and accrue to both EU innovating and manufacturing countries.

Within the model, reducing internal frictions can have the same effect as reducing trade and multinational production costs between EU member countries. This allows comparative advantage to more fully determine how resources are allocated within and across member countries. All member countries benefit from reduced costs and wider variety of goods. The spillovers to non-EU countries are on net small, allaying concerns that non-EU countries would be worse off. In particular, the small spillovers to China reflect that EU firms’ production in China is mainly to cater to final demand in the region. A more integrated EU would therefore not lead to substantial reallocation of production or trade diversion to the EU.

In contrast, the recent surge in national measures, including to address the energy price shock, risks damaging the Single Market by giving those countries that provide large fiscal support to their industries a competitive edge over their EU peers. Instead, centralized coordination is needed to protect the level playing field.

This is best illustrated in the area of decarbonization. Given the externalities from carbon emissions, decarbonization targets should be set at the EU level, rather than at the level of individual members, to make sure efforts are concentrated where marginal abatement costs are lowest across the EU. This will ensure the largest possible emissions reductions are achieved for a given amount of green investment.

Replacing coal—which is still heavily used by some countries, such as Poland and Germany—in electricity generation is generally seen as the least-cost way to decarbonize.

Within a strengthened Single Market, any reliance on industrial policies should be restricted to addressing market distortions and be targeted and time bound. Caution is needed to avoid government capture and the rent seeking behavior that will follow. To that end, industrial policies should not give preference to one type of technology over another and avoid favoring incumbent firms over new entrants or giving preference to domestic over foreign firms.

For instance, there is arguably a role for government intervention to de-risk energy supply and slow climate change, including through providing support for renewable energy production and establishing the critical network infrastructure of smart grids and EV charging stations. To finance these interventions, an EU-wide central fiscal capacity of a meaningful size can help ensure resources flow to where they have the highest benefits, and not where governments are more able and willing to provide state aid.

That said, the temptation to subsidize energy prices during the green transition should be resisted. Fossil fuel prices are not expected to return to the low levels of before the war in Ukraine over the next several years, at least. This suggests that the least energy-efficient firms in activities that are intensive users of energy may no longer be internationally competitive at current energy prices. Choosing to subsidize fossil fuels would tend to lock in their use and blunt the price signals that favor renewables, slowing down the transition. While EU firms are on average more energy efficient than elsewhere, there is a wide dispersion. This suggests ample scope for lagging firms within each industry to catch up, thereby reducing the burden of energy costs on their competitiveness.

Let me conclude. While geo-economic fragmentation has become a reality, it is still in its early stages. It is on us to determine the extent to which it will affect the global economy.

Some realignment of economic relations is clearly necessary given the new geopolitical realities. However, there is no reason to risk a disorderly breakdown of global relations. And leaders are stepping up. The recent meeting of President Biden and President Xi at the APEC Summit and the planned EU-China summit to be held in early December are all vitally important to avoid a race to the bottom where everyone loses.

Our research shows that an extreme form of geoeconomic fragmentation in trade could wipe out 7 percent of global GDP over the medium run. With rival economic blocs and estranged global relations, this would be a world that is not just less prosperous but also less safe in terms of both economic and national security.

Europe may be best placed to demonstrate how cooperation can help us navigate a more divided world. In the wake of the Second World War, Europe launched one of the most audacious political experiments in history: finding unity through collaboration among sovereign nations. The pioneers of the European Union knew—after living through the nightmare of two world wars—that it was in everyone’s interest to balance national interests and build a united Europe. Nearly eight decades later, the EU embodies that dream.

Today, we are being tested again by global tensions. Only now, we are more connected than ever by the global challenges we face, from climate change to the rise of disruptive technologies. To have any chance of solving those challenges, we need to follow the EU’s lead and search for common ground.