Tariffs and Trade

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The Republican nomination of Donald Trump as its nominee for President ensures that international trade will be a major issue in the campaign. Trump views trade as a zero-sum game and the existence of U.S. trade deficits as proof that other nations have taken advantage of U.S. openness (= weakness). Tariffs are the primary policy tool to respond to the unfair treatment of U.S.-made goods and even the playing field.

Trump, of course, had (and has) many advisors in his first term as President who share  his views, such as Robert Lighthizer and Peter Navarro. But there are other Republicans not affiliated with Trump who have similar views. Oren Cass is chief economist at American Compass, a conservative think tank. He graduated from Williams College with a degree in political economy and has a law degree from Harvard. He recently (July 17) was a guest on Ezra Klein’s podcast to discuss the foundations of the economic “populism” advocated by a number of the younger representatives of the Republican Party. These include Senator J. D. Vance, the Republican Party’s Vice-Presidential candidate.

Oren Cass is a very bright fellow, and I always read his newspaper columns. He articulates his line of reasoning.very well. I chose his particular line of reasoning because he raises many legitimate points. Part of the discussion (see transcript here) dealt with Trump’s proposals to impose 10% tariffs on all goods and 60% tariffs on Chinese goods. Cass’ justification of the proposals deserves scrutiny. He makes the statement that the U.S. $1 trillion deficit includes foreign-made goods that could have been made here:

“ …what you’re doing is you’re taking what would otherwise have been demand for things that are produced in America and you’re just eliminating it. You’re just saying there is now less demand for stuff made in this country.”

He goes on to say that this is “a terrible model”, particularly for American workers in communities where manufacturing can be productive.

There is a lot to unpack from Cass’ claims. His statement about buying foreign goods rather than American made goods implies that if we cut imports to zero, GDP would rise as we switch to the production and sale of the domestic versions of the goods. But there are legitimate reasons to purchase foreign goods. Coffee is grown in Hawaii, but do we expect that at higher prices Hawaiian or other U.S. made coffee could replace coffee from Asia, Africa and Latin America ?

Other goods could be produced here but at higher prices. At one point Cass points out that iPhones were designed in California but assembled in China. One of the reasons for Apple’s original decision to locate production in China was cheaper costs. As a result of the rise in Chinese wages and political factors, Apple is looking at establishing a production facility in India, while other companies have moved to Vietnam.

All this could be interpreted as examples of countries using their comparative advantage to produce exports and attract foreign investment. But Cass states that comparative advantage “…does not describe a modern industrial economy. Comparative advantage is really created, not discovered and based on who invests in what.” He cites semiconductor manufacturing as an example of an industry where foreign firms became the dominant suppliers because of subsidies from their home governments. There may indeed be a case for using subsidies and other industrial policy measures to maintain domestic production of some strategic goods, and a subsidy is preferable over a tariff. Economies do evolve, and China now produces goods that it did not in the 1990s. But the definition of a “strategic good” is subjective and was certainly overused in the Trump administration.

There are products that do not fit under the umbrella of “strategic good,” such as textiles. And yet Cass seems to believe that we could successfully compete in these fields as well. Klein states at one point that it is difficult “…to imagine a world where most garments that Americans wear are made in America.”  At the end of the interview, Cass replies: “…garments are an extraordinary potential area of innovation. And I would love to see our policy be – it’s going to be more expensive if you have to use foreign stuff than if you can use domestic stuff. Now, companies of the free world, investors of the United States, go forth and figure out what to do.”

Cass has a strong belief in the powers of U.S. ingenuity. But there are several responses. First, does he believe that it is possible to devise a way of manufacturing garments in this country that is cheaper than using Bangladeshi laborers? Multinational firms would have adopted the new machinery by now if were feasible.  Second, are there any goods or services that we import that he believes we should accept? His arguments are consistent with a mercantilist view that exports are needed to project national power that imports diminish. Third, what happens when other countries retaliate with their own tariffs? Do we enter a downward spiral of trade, as occurred in of the 1930s?

Moreover, all these trade measures involve costs that will show up at some point in the price of the protected goods. But Cass is not concerned about this aspect of protectionism. In response to a question from Klein about the public response to higher prices because of tariffs, Cass responds that if higher prices were linked to policies favored by the public, then the public will accept them: “…when you tell people honestly, here are the ups and downsides of a tariff—one of the downsides of a tariff is it raises prices—that doesn’t reduce support for tariffs.” The public may indeed tell a pollster that they are willing to accept hypothetical higher prices (just as they claim to be willing to accept cuts in government expenditures), but the reality of higher prices (or spending cuts) may produce a very different response.

Perhaps most surprising, Cass does not tie the trade deficit to its macroeconomic determinants, savings and investment. Students in the Principles of Macroeconomics course learn that the trade deficit (X- M) equals the gap between Investment spending (I) and private and public, i.e. government, savings (S, (T – G)):

X – M = (S + (T – G)) – I

If investment is greater than domestic savings, then it must be financed by foreign savings in the form of capital inflows through the financial account. The trade and financial accounts are mirror images of each other, so a surplus in the financial account must be offset by a trade deficit.

This is not a theorem—it is an identity. It holds true because of how Gross Domestic Product and the balance of payments are defined. But the relationship between investment and savings implies that closing the trade deficit requires a change in savings, beginning with fiscal deficits. Trump showed in his first term that he was quite willing to sacrifice fiscal solvency for a tax cut, and nothing has shaken his enthusiasm for tax cuts.

 The battle over trade, therefore, will be fought over tariffs. Again, I am not denigrating Cass. Biden was willing to use tariffs as part of his industrial strategy and it is difficult to imagine any other candidate forsaking their use. That leaves a continuation of financing the deficit with capital inflows. These could include attracting FDI by foreign firms or issuing more Treasury debt to be held by foreign investors as “safe assets.”  Until the root cause of the trade deficit is addressed, these other measures only distort trade patterns and push up prices.

Has Globalization Been Reversed?

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The disruption of the global economy caused by the COVID pandemic in 2020 had begun to be overcome when the Russian invasion of Ukraine in 2022 led to new fissures. Sanctions were placed by the United States and European nations on trade and capital transactions with Russia. Before the pandemic, tariffs and other trade measures had been imposed by the  United States and China on each other, and these restrictions were continued under the Biden administration. How far has the reversal of the measures designed to promote international trade and finance gone, and has globalization been set back?

 Jesús Fernández-Villaverde, Tomohide Mineyama and Dongho Song in a new NBER working paper, “Are We Fragmented Yet? Measuring Geopolitical Fragmentation and Its Causal Effect,” devise an empirical measure of geopolitical fragmentation using a dynamic factor model.  They selected 14 indicators, including economic measures such as FDI/GDP, the number of trade restrictions, and migration flows as well as political indicators, such as the number of international conflicts. The data begin in 1975 and include 61 countries, 34 advanced and 27 emerging markets. Their measure shows a high degree of stability between 1975 through the early 1990s, when political events led to a decline in fragmentation, as the Soviet Union dissolved, the World Trade Organization was formed, and the euro was created. This trend began to reverse during the time of the 2008-09 financial crisis, and the estimated fragmentation index has steadily risen.

The authors then use their index to examine its impact on economic outcomes, including the impact on GDP per capita, industrial production and fixed investment. They find that a rise in fragmentation affects the global economy adversely, with emerging economies suffering more of an impact. They also find asymmetries in the timing of the effect of an increase in fragmentation vs. a decline, with the negative effects of a rise in fragmentation taking place more quickly than the positive impact of a decline in fragmentation.

A different view of the extent of fragmentation has been presented by Steven A. Altman and Caroline R. Bastian in “The State of Globalization in 2023”, which appeared in the July 2023 issue of the Harvard Business Review. Both authors are affiliated with the DHL Initiative on Globalization at NYU’s  Stern Center. They used the DHL Global Connectedness Index, which measures the growth of trade, capital, people and information relative to the growth of the domestic economy. The first three measure declined in response to the COVID pandemic, but trade and capital have recovered. International travel has not returned to pre-pandemic levels, although migration has. Flows of information, on the other hand, increased during the pandemic and afterwards as people turned to the Internet after shutdowns limited public activity.

The authors did find evidence of a drop in U.S.-China economic flows, although the two economies still have substantial linkages. Moreover, they report that allies of each country have not reduced trade with the other country. Regionalization has not succeeded globalization, and the authors claim that firms that retreat from globalization may lose a firm’s competitive position.

An analysis of one country’s response to fragmentation is presented in “Germany’s FDI in Times of Geopolitical Fragmentation”, a 2024 IMF working paper by Kevin Fletcher, Veronika Grimm, Thilo Kroeger, Aiko Mineshima, Christian Ochsner, Andrea F. Presbitero, Paul Schmidt-Engelbertz and Jing Zhou’s. Germany is sensitive to external shocks, such as the rise in energy prices that followed the Russian invasion and the authors sought to determine how geopolitical risk and energy prices could affect FDI flows. Among their findings they report that the post-pandemic recovery in both inward and outward FDI have been slower in Germany than in the U.S. or the rest of Europe. They also find that Germany’s outward FDI linkages with geopolitically distant countries have been weakening, in particular FDI to China-Russia-bloc nations.

Measuring and analyzing fragmentation and its consequences will remain an active area of research. Compounding the challenges of obtaining relevant data is the uncertainty of the future. The pace and extent of globalization will be driven in part by political decisions. By the end of this year there will be executive changes in many of the  largest economies. Consequently, the political landscape will change and new restrictive policies could impede the integration of markets. National leaders will assess the challenges they face and the responses they choose may diminish global, welfare.

The Fragmentation of FDI

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The expansion of firms to foreign countries can be traced back to the establishment of the British East India Company and the Dutch East India Company (VOC) at the beginning of the 17th century. U.S. based firms have been involved in foreign operations for over a century. In the 1990s the improvement of information and communications technology allowed managers in the home countries of multinationals to coordinate the activities of their production units in developing economies. FDI flows to those economies grew and their activities contributed to the profits of their parent firms. But recent analysis shows that there has been a slowdown of foreign corporate expansion and changes in its allocation and destinations.

The OECD’s FDI in Figures for April 2024 reports that global FDI flows fell by 7% in 2023, continuing a downward trend following the pandemic. Australia and the U.S. were among the OECD countries with the largest decreases of inflows. Despite this drop, the U.S. remained the largest recipient of FDI inflows ($341 billion) among all countries, followed by Brazil  ($64 billion) and Canada ($50 billion). The report also noted that FDI inflows to the G20 countries fell last year by 34%, and by 46% to the non-OECD members of the G20. The latter figure included major reductions in inflows to China.

The IMF examined the changes in the allocation of FDI in a chapter of the 2023 World Economic Outlook. The authors of the chapter note that the recent fragmentation of trade and capital flows along geopolitical fault lines is a new phenomenon. If these changes in the allocation of direct investment continue (“friend-shoring”), FDI will become more concentrated within blocs of politically aligned countries. Moreover, other forms of capital flows, such as portfolio flows, are not immune to this reallocation.

This relocation of multinational activities will have negative effects on emerging markets and developing economies, which are less likely to be politically aligned with the U.S. or China. These countries depend on FDI for capital and technological deepening, and their own companies benefit from the entry of foreign firms into the domestic economy. Changes in FDI related to vertical integration, which is associated with economic growth, are particularly most costly for these countries. Simulations undertaken by the IMF’s economists project a drop in long-term global GDP of 2%.

The authors looked at FDI flows that included “strategic FDI,” i.e., FDI linked to national and economic security concerns. The flows of strategic FDI to Asian countries, and particularly China, have fallen sharply. On the other hand, this type if FDI was more resilient in Europe and the U.S. The allocations point to a growing  gap between Europe and Asia in this sector.

The issue of fragmentation also appeared in a 2024 IMF Working Paper, “Changing Global Linkages: A New Cold War?” by Gita Gopinath, Pierre-Olivier Gourinchas, Andrea F. Presbitero and Petia Topalova. The authors note that  the reallocation of trade and investment flows among countries is taking place, triggered in part by the tensions between the U.S. and China. They report that trade flows and FDI between a U.S. centered bloc and a China centered bloc has declined by 12–20%, more than trade and investment within countries in the same bloc. However, several nonaligned countries, such as Mexico, Canada and Vietnam, serve as connectors, receiving Chinese goods and reexporting them to the U.S. The global economy, therefore, is not cleaving in half, but it is showing symptoms of fragmentation.

Many of the themes developed in the IMF papers also appear in a recent UNCTAD report, Global Economic Fracturing and Shifting Investment Patterns.  These authors also find evidence of fracturing in global FDI along geopolitical lines and evidence of instability in investment relationships. There is also a gap between investment in the manufacturing and services sectors, with the latter growing in importance. In addition, the authors find evidence of increased FDI in environmental technologies.

A similar assessment of the changes in global trade and investment is offered by Barry Eichengreen in a working paper, “Globalization and Growth in a Bipolar World.” He points out that investment that might have gone from the U.S. to China and vice-versa now is directed to third countries that serve as bridges between the two. This (supposedly) leads to an improvement in national security in exchange for less efficiency. But it may take years to form a quantitative assessment of that tradeoff.

Limitations on FDI flows due to security concerns are a relatively recent phenomenon. They are part of a larger transition to new manifestations of  industrial policy. The downside with such policies is that protectionist motives can guide their imposition and continued use.  Imposing restrictions is always easier than removing them.

Japan’s Net Income Surplus and Its Exchange Rate

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Japan’s current account surplus may not be a surprise to those of us who remember Japan as a major exporter. But a closer examination shows that the current account surpluses recorded today are not due to the trade account but rather the net primary income balance. Japan used the trade surpluses of the 1970s and 1980s to build up its holdings of foreign assets and prepare for the day when it would need income from abroad to pay for its aging population. Last year, according to The Economist, the country earned a net $269 billion on its primary income balance, equal to 6% of its GDP.

Mariana Colacelli, Deepali Gautam and Cyril Rebillard of the IMF examine Japan’s income balance in their 2021 working paper,“ Japan’s Foreign Assets and Liabilities: Implications for the External Accounts.” They point out that the surplus reflects Japan’s status as a net creditor nation, as shown by its Net Investment Income Position of $5.4 billion, which equals 63% of its GDP.  The surplus reflects higher yields on its foreign assets than its liabilities , including both foreign direct investment as well as portfolio equity and debt assets. The U.S., on the other hand, has a surplus on FDI income but a deficit on its portfolio-related return.

Japan’s income balance is negatively corelated to its trade balance, and this relationship holds for other countries. They cite several factors that could be relevant in Japan’s case, including:

  • aging population, which uses its assets to finance consumption (including imports);
  • income effect, which boosts spending on imports;
  • offshoring by multinationals, which shifts income from exports to income received from the multinationals’ subsidiaries.

Colacell, Gautam and Rebillard also study the response of the income balance to changes in the real exchange rate in order to compare this with the response of the trade balance. An appreciation of the real exchange rate in a country like Japan with a large net creditor position would likely lead to a decrease in the income balance, reinforcing the expected trade response to an appreciation. On the other hand, a currency appreciation in a net debtor nation would most likely lead to an increase in the income balance, which would lead to an income surplus that could offset the trade response.

They present evidence of negative responses in the income balance to an appreciation. This result differs from that reported of Takahiro Hattori, Ayako Tomita and Kohei Asao in a new working paper from the Policy Research Institute of the Japan’s Ministry of Finance, “The Accumulation of Income Balance and Its Relationship with Real Exchange Rate: Evidence from Japan.” They use data from 1999 through 2020 and find that the real exchange rate does not have a significant impact on Japan’s real exchange rate.

They expand their empirical analysis to a panel of 39 countries, and find again that the estimates of the real exchange rate impact on the income balance are insignificant. These results are similar to those reported by Enrique Alberola of the IMF with Ángel Estrada and Francesca Viana of the Bank of Spain in their 2020 paper in the Journal of International Money and Finance, “Global Imbalances from a Stock Perspective: The Asymmetry between Creditors and Debtors.” (BIS working paper version here). They investigated the impact of the role of the net income balance on the adjustment of the current account via the real exchange rate using annual data from 1980-2015, but found no evidence of such an effect. I also looked at the response of the income balance to the dollar exchange rate in 26 emerging market countries during the period of 1998– 2015  in my 2020 paper in the Review of International Economics, “The Sources of International Investment Income in Emerging Market Economics”, and did not find evidence of an impact of the exchange rate.

Further evidence on this channel of transmission to current account imbalances via the exchange rate impact on the net income balance appears in Alberto Behar and Ramin Hasan’s of the IMF in their 2022 working paper, “The Current Income Balance: External Adjustment Channel or Vulnerability Amplifier?” They did find evidence of a significant effect of the exchange rate on income credits and debits. However, these effects are relatively small when compared with the impact on the trade balance.

Japan’s net income balance, therefore, may an outlier in terms of its size and position in that country’s current income. However, the increasing importance of net income balances and their impact on a country’s balance of payments will necessitate further work on this topic. In particular, the role of the exchange rate in determining the primary income balance canl be further examined.

The Impact of FDI Income on Income Shares in Home Countries

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Income generated by foreign direct investments (FDI) has grown since the 1990s, and now represents a substantial portion of many countries’ current accounts. Some of these flows are routed through Special Purpose Entities in financial centers that multinational firms use to minimize their tax liabilities. We use IMF and OECD data to evaluate the impact of this income on the income share of the top 1% of households in the multinationals’ home countries. We distinguish between FDI equity income and FDI interest income arising from intra-firm lending. We also consider separately the effects in advanced economies rom those in financial centers. FDI equity income contributes to the income share of the top 1% of households in advanced economies, while FDI interest income has no impact in these economies. Similar results for these countries are recorded when we use the OECD non-SPE data. As a result, total FDI income reinforces the income share of the top 1% of households in these countries. While there is some evidence of a similar impact by FDI equity income on the top 1% of households in the financial centers, this result is not apparent when non-SPE income data are used.

See paper here.

Catching Up

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I have not posted anything for several months as I have been kept quite busy with professional and family tasks. I would like to return to posting, even on a less frequent basis. So, the next post will be about a new journal article of mine.

I will be also writing about international investment income. These arise from FDI assets, portfolio equity and bonds, and “other” items, principally bank loans. I am preparing a monograph on the subject and will share some. of my findings.

China’s Missing Income

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The earnings of a country’s multinational firms appear in its balance of payments in the primary income component of the current income balance. Primary income includes the net flow of income received for the provision of a factor of production, such as labor, financial or other assets, to and from nonresidents. Investment income is usually the largest component of these income flows, and income from FDI appears there with income from portfolio and other types of investments (such as banks) as well as income from the central bank’s reserves.

The countries with the largest net flows of foreign direct investment income in 2021 were:

U.S.                    $348.9 billion

Japan                 $95.4 billion

Germany           $90.4 billion

France               $54.1 billion

Netherlands    $34.7 billion

U.K.                  $25.6 billion

(The Netherlands data exclude income flows associated with Special Purpose Entities, which serve as conduits for FDI flows.)

The ranking of countries by FDI income receipts can be compared with the listing of countries by the number of multinational firms with headquarters located in their borders. Pizzola, Carroll and Mackie (2020) of Ernst & Young provide a ranking of countries by the number of Fortune Global 500 firms headquartered in their jurisdictions. The U.S., Japan, France, Germany and the U.K. all appear at the top of the list. But the country at the number one position with the largest number of multinationals is China. Why doesn’t China also appear in the list of top FDI recipients?

There are several answers. First, China does not report the values of the components of its primary income, so we do not know what its net FDI income is. But it does report total net primary income, and that balance has almost always been negative. If FDI income is the largest component of primary income as it is for many other emerging market countries, then it has been contributing to the primary income deficit.

Second, while China is a net creditor nation with an overall net international investment position in 2021 of $2.2 trillion, its direct investment assets are less than its liabilities: $2.79 trillion vs $3.60 trillion, or net $ -0.82 trillion, according to the IMF’s Balance of Payments data. Similarly, while China has become a major source of FDI outflows, FDI inflows are larger: $178.8 billion in the acquisition of assets vs. $344.1 in the acquisition of liabilities in 2021. As long as investments into China exceed its own foreign acquisitions, the flow of income derived from these activities will be negative.

Brad Setser of the Council of Foreign Relations has also written about China’s primary account. He is puzzled by is decline in the decline in the balance in the second quarter of 2022 at a time when foreign holdings of Chinese bonds were falling. He also writes that:

“China was locked down and its economy shrank—not an ideal environment for foreign firms to make large profits.”

Pizzola, Carroll and Mackie point out that the headquarters of the multinational firms have over time shifted away from the U.S. and other members of the Group of 7 nations (Canada, France, Germany, Italy, Japan, U.K., U.S.) While the U.S. still accounts for the second largest number of headquarters, its total declined between 2000 and 2020. Japan also registered a decline in the number of multinational firms headquartered there. As other counties become the headquarters of multinational firms, their FDI income receipts will rise as well

The primary account balance plays an important role in many countries’ current accounts. In China, for example, in 2022 the surplus in the current account of $401.9 billion was smaller than the trade balance surplus of $576.3 billion because of the deficit in the primary account of  $193.6 billion. (Secondary income, which includes remittances, registered a surplus of $19.1 billion.)  It would be useful to have the full data on primary income to understand what is driving this component of China’s balance of payments.

Threats to Financial Hegemony

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The U.S. came out of World War II with the largest economy and a predominant place in the post-WW II international financial order. It was the only nation that could provide the international leadership that Charles Kindleberger wrote was necessary to avoid catastrophic events such as the Great Depression of the 1930s. But in return for stability the U.S. also received a degree of control, and that legacy is under attack today.

American financial hegemony evolved in the years following the end of WW II.  Capital flows were severely regulated under the Bretton Woods regime so that national governments could maintain autonomy over national monetary policy and also to avoid destabilizing speculation. But as international trade picked up the dollar served as a vehicle currency, which led to the U.S. serving in the role of what Emile Despres, Charles Kindleberger and Walter Salant called the “world’s banker.”

In 1971 President Richard Nixon revoked the U.S. pledge to accept dollars from foreign central banks in exchange for gold. But the end of this linkage did not diminish the use of dollars as an international reserve currency. Private capital flows continued to expand as governments deregulated their capital accounts and the dollar had a central role in the growing international financial markets.

Andrew Sobel identified the attributes of a financial hegemon in Birth of Hegemony. These include large and liquid capital markets and openness to foreign capital flows. In addition, Kindleberger in his account of the role of an international financial leader in The World In Depression specifically referred to the need for international liquidity. U.S. government actions, including those of the Federal Reserve, have been consistent with these principles (see here). Capital flows are largely unregulated, while the Federal Reserve has used swap agreements to provide dollars to foreign central banks which in turn could use them to maintain dollar funding in foreign financial markets.

Consequently, while other currencies such as the euro and the Japanese yen have been considered as possible rivals for the dollar, no single viable alternative has emerged. But Serkan Arslanap of the IMF, Barry Eichengreen of UC-Berkeley and Chima Simpson-Bell, also of the IMF, have shown in their IMF working paper, “The Stealth Erosion of Dollar Dominance: Active Diversifiers and the Rise of Nontraditional Reserve Currencies,”  that the composition of international reserves has shifted away from the dollar over time. This decline has been offset by a rise in what they call nontraditional currencies, including the Chinese renminbi but also the Australian dollar, the Canadian dollar, and the Swiss franc.

Two recent developments have reopened the question of the continued central role of the dollar. The first is the seizure of more than $300 billion of foreign currency assets of the Russian central bank in the wake of Russia’s invasion of Ukraine. This seizure, while not unprecedented, raises legal and political questions. To date the U.S. and its European allies have resisted confiscating these funds to assist the Ukrainian government, but the pressure to do so will mount as the war continues. The confiscation of the Russian central bank’s assets certainly causes other foreign central banks to reassess the composition of their foreign exchange holdings. Moreover, the People’s Bank of China has established its own swap lines to foreign central banks.

The second event is the debate that took place within the U.S. over the debt ceiling. This political theater was resolved, but the opposition of some Republican legislators to any increase in the U.S. Treasury’s borrowing authority triggered a reassessment of whether U.S. Treasury bonds are truly “safe assets.” When governments default on their debt, it usually is because economic conditions have curbed their ability to raise funds through domestic taxes or to roll over their debt. The U.S. situation is different: the government faced a self-inflicted attempt to force the Treasury into a position where it might not have made payments on its debt. Several bank failures had already, according to the IMF, shown the extent of U.S. financial fragility, and a debt default would have severely escalated the volatility.

Either of these events—the confiscation of Russian assets or the threat of a failure to raise the U.S. debt ceiling—is probably sufficient to increase the pace of currency diversification in central bank reserves.  But replacing  the U.S. dollar in the international financial system will be a more complicated task. First, as Michael Pettis has observed, the global role of the dollar allows the U.S. to offset the savings imbalances that exist in countries such as China, Saudi Arabia and South Korea. If the U.S. did not offset the current account surpluses of those and other countries, then either they would have to find a substitute or increase their domestic demand.

Second, international capital markets still deal in dollars. Bafundi Maronoti of the Bank for International Settlements points out in his examination of the international role of the dollar in the December 2022 issue of the BIS Quarterly Review that “About half of all international debt securities and cross-border loans issued in these offshore funding markets are denominated in USD.” It is difficult to imagine how any other currency could take the place of the dollar in these markets.

There are legitimate questions, therefore, about the dominance of the U.S. dollar in international finance. Central banks will continue to diversify the currency denominations of their foreign exchange holdings. But the dollar’s central role in global financial flows will not be easily replaced.

The Costs of the Defragmentation of the Global Economy

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The integration of markets across borders has slowed down, and in some cases, reversed. These changes come in the wake of the global financial crisis, Donald Trump’s embrace of trade restrictions, Great Britain’s withdrawal from the European Union, the disruptions in global supply chains during the pandemic, and the invasion of Ukraine. President Biden has shown a willingness to use trade and financial restrictions in response to what he views as Chinese and Russian threats to U.S. strategic interests, and there are responses to the use of sanctions and other tools of disruption. The fallout from this rift will take years to play out.

A team of IMF economists have written a Discussion Note on Geoeconomic Fragmentation and the Future of Multilateralism. They attribute the reversal of economic integration to national considerations, such as the desire of governments to increase their domestic production capabilities in particular areas. But the authors of the Note point out that while fragmentation may achieve some goals, it also imposes costs. These include: “higher import prices, segmented markets, diminished access to technology and to both skilled and unskilled labor, and ultimately reduced productivity which may result in lower living standards.” Moreover, fragmentation will slow down joint efforts to address global issues such as climate change.

The Discussion Note summarizes the results of several studies of the loss from geoeconomic fragmentation. In all the studies they cite, the costs are greater the larger the degree of fragmentation. Among the reasons for the losses in output are reduced knowledge diffusion due to technological decoupling. Not surprisingly, low income and emerging market countries are most at risk from a separation from the latest technological developments.

Pinelopi K. Goldberg of Yale and Tristan Reed of the World Bank Group (Goldberg is former chief economist of the World Bank) examine the prospects for global trade in their recent NBER Working Paper “Is the Global Economy Deglobalizing? And if so, why? And what is next?” They find that “slowbalization” is a better description of the recent trend in international trade than “deglobalization.” Foreign direct investment and migration have exhibited relatively less slowdowns. But the authors also document changes in U.S. policies and public attitudes that represent a marked shift away from the liberalization of trade. They attribute these reversals to various factors, including the impact of imports on U.S. labor, concerns over the resilience of global supply chains, and national security considerations.

Goldberg and Reed conclude their analysis with some projections of the consequences of deglobalization. They point out that the previous regime of the last three decades led to growth and technological progress They warn that global innovation will be particularly slowed by a decoupling of the U.S. and China  Reconfiguring production supply chains will slow growth as well. These reversals and changes raise the possibility that the recent decline in global inequality will halt, with low-income countries most at risk.

Trade, of course, is not the only component of international commerce that has undergone changes in how it is organized. Chapter 4 of the IMF’s most recent World Economic Outlook analyses the geoeconomic fragmentation of FDI. The authors point to an increase in the “reshoring” and “friend-shoring” of production facilities domestically or to countries with similar political alignments. They estimate a model of the impact of geopolitical alignment on FDI flows, and find that geopolitical factors account for part of the shift in bilateral FDI to countries with governments with similar views to the home country. This could presage a shift to more FDI among advanced economies, rather than emerging markets and developing economies that may differ on political issues.

The Fund’s economists also analyzed the output costs of FDI fragmentation. They utilized different scenarios of geopolitical alignment, such as a world divided into a U.S.-centered block and a China-centered block, with India and Indonesia and Latin America and the Caribbean as nonaligned. In this scenario, the impact of smaller capital stocks and less productivity cumulate with long-term output losses of 2%. Other scenarios allow for the diversion of investment flows to some areas that could offset a decline in global economic activity. However, the chapter’s authors also warn that nonaligned nations may face pressures to choose one side over the other. They conclude from their analysis: “…a fragmented global economy is likely to be a poorer one. While there may be relative—and possibly absolute—winners from diversion, such gains are subject to substantial uncertainty.”

Other forms of capital flows are also subject to fragmentation, and the IMF’s economists examine these trends is a chapter of the latest Global Stability Report. In their analysis, geopolitical tensions can lead to instability through two channels. The first is a financial channel that could respond to increased restrictions on capital flows, greater uncertainty or conflict. The second channel is a real channel, due to disruptions in trade and technology transfers or volatile commodity markets. These two channels can reinforce each other. Restrictions in trade, for example, could discourage cross-border investments.

Geopolitical affinities affect cross-border capital allocation, and the evidence reported in the chapter indicates that recent events have reinforced this impact. The empirical analysis based on a gravity model finds that a rise in geopolitical tensions can trigger sizable portfolio and bank outflows, particularly in developing and emerging market economies. Geopolitical fragmentation can also lead to a loss in international risk diversification, thus leaving countries more vulnerable to adverse shocks and a sizable welfare loss.

All these analyses from multilateral institutions warn of the negative economic consequences arising from the decoupling of trade and financial ties. But the most threatening effects may come from the deepening division of the world into different blocs. As the dividing lines become solidified, the chances of discord extending beyond economic interactions increase. All this friction arising when climate warming already poses a clear threat to our existence only intensifies the dangers we will face.