The fragmenting of free trade around the world and the rise of industrial policy have resulted in the nascent formation of a trade, finance and currency bloc organized around American economic and security interests.
The democracies in the West and their primary trading partners in Asia excluding China appear to be coalescing around mutual economic and security interests.
Although not formalized, the democracies in the West and their primary trading partners in Asia excluding China appear to be coalescing around mutual economic and security interests in a de facto dollar bloc with the U.S. Federal Reserve as the lender of last resort.
A trading bloc of democracies would include more than 56% of the world’s gross domestic product. China, by contrast, has a 16.9% share of world GDP, while India has 3.9% and Russia 1.9%.
In some respects, this dollar bloc evolved out of the crucible of the financial crisis and lessons learned around supply chain resilience during the pandemic. These factors unleashed a populist economic revolution around the world that has intensified tensions between China and the rest.
This new economic order, led by a resurgent American economy, is taking place against the backdrop of China’s deleveraging and its trade policy of the disgorging manufacturing in the West.
The emphasis of this new dollar bloc will be on supply chain resilience, domestic employment, added-value manufacturing and the protection of emerging industries around artificial intelligence and quantum computing.
Identifying the problem
China’s share of world exports increased from less than 3% in 1999 to nearly 16% in 2021, according to Bloomberg. But China’s shutdown during the pandemic was a wakeup call to its trading partners to begin diversifying to other nations.
Now, China’s share of total exports has decreased to 14.7% this year.
To be sure, the U.S., the EU and China are still heavily reliant on one another. China has a $350 billion trade surplus with the U.S. and a $230 billion surplus with the EU. China’s trade surplus with the UK is $50 billion a year.
The success of the U.S. model
The monetary and fiscal policies since the pandemic have turned a slow-growing U.S. economy into a world leader.
A number of factors is driving this growth: income support during the pandemic, infrastructure spending, investments in building microchips and energy diversification. The result has been higher household incomes and spending, and a resilient economy.
And because interest rates were so low for so long, private investment by businesses is creating the foundation for the next generation of economic activity.
With the economy now capable of supporting higher rates of return, capital is flowing into the U.S., which only adds to the investments in technology and productivity.
This technological advantage will benefit the U.S. military as well as it projects its power across the globe.
The dollar was the world’s reserve currency before the economic and political shocks of the past 15 years and that status is not changing.
Nearly all, or 96%, of total foreign exchange reserves, which are held to cover a nation’s international liabilities, are denominated in the currency of one of six western democratic nations. Nearly 58% of reserve holdings are denominated in U.S. dollars, 20% are in euros, 6% are in yen, and 5% are in British pounds.
Only 2.1% of total reserves are held in Chinese yuan.
Industrial policy and the dollar bloc
Democracies have learned that the global economy is not a zero-sum game. The growth of one economy does not preclude the growth of another.
But now these democracies find themselves countering Russia’s aggression and China’s state-run mercantilist trading practices.
In Europe, NATO is supplying arms to counter Russia’s invasion of Ukraine and is having to find other sources of energy to replace Russia’s cut-off of supplies.
As for China, the U.S. has turned to industrial policies like the public-private financing of the semi-conductor industry, the creation of tech hubs to foster technology throughout the country, and the imposition of tariffs on Chinese electric vehicles and parts.
In 2022, the Biden administration’s industrial policies resulted in criticism.
Was the U.S. trying to corner the semiconductor market?
But last year, the European Union passed the Net Zero Industry Act aimed at fostering the development of clean technologies. And in September, Mario Draghi, former prime minister of Italy and head of the European Central Bank, released his roadmap for the EU.
It is clear that one era has ended and another has begun that will be organized around far larger participation of the state in shaping economic outcomes.
“The Future of European Competitiveness” affirms the need for industrial policy to improve the competitiveness of European economic activity.
We see it as perhaps the first step toward coordinated fiscal policies between the U.S. and the EU.
We have already seen the progression of monetary policy from isolation to commonality among the central banks in recent decades. Out of the multiple shocks beginning with the financial crisis, a consensus is apparent among monetary policies.
Whether this is born out of self-interest or coincidence is immaterial; the central banks are working in unison to ensure the liquidity necessary for commercial activity to continue functioning in times of stress.
One of the major lessons learned during both the financial crisis and the pandemic is that the Federal Reserve will open its potent swap lines to ensure there are no dollar shortages for its critical trade partners at critical times of stress in its global trade and financing bloc.
Recent events now call for the coordination of industrial policies.
A new Cold War?
It is our contention that the global economy has split into three camps.
One group consists of the Western democracies in North America, Europe and Asia (Japan, South Korea, and Taiwan), and in the Southern hemisphere (Australia and New Zealand). These countries have formed what has become a nascent dollar-bloc, consisting of like-minded central banks and economies based on consumer choice and market-based decisions.
The second group consists of the government-controlled economies in Russia, China and OPEC.
A third group consists of the emerging economies that struggle to balance protectionism, growth and national security interests and their dependence on support from the West or now China. This group includes India, which is caught between its democratic roots and its access to Russian armaments and oil.
The spilt might have always been in the making. The Nobel Prize in economics recently went to economists who linked prosperity to countries with roots in democratic institutions, respect for the rule of law and a commitment to property rights.
Nevertheless, it was the pandemic that hit the reset button and exposed the cracks in the global economy and in so-called neo-liberal economics.
Instead of a winner-take-all philosophy that prospered between 2000 and 2020, the global economy can still benefit from the policies that rebuilt Europe and Japan after the second world war.
There are theoretical reasons for domestic and international investments in each other’s growth. As Keynes would see it, unemployment is a breeding ground for fascism, and economic instability remains a catalyst for conflict, Zachary D. Carter wrote in “The Price of Peace.”
We can see those propositions in today’s political divisions in Europe, with its industrial base trying to fend off competition from China and with workers struggling with immigration.
China’s cornering the market to the exclusion of all others is reason enough for industrial policies.
What’s next
Two recent articles map out solutions for dealing with China.
The first, by Aaron L. Friedberg, a political scientist at Princeton and a former national security advisor, advocates a trade defense coalition among developed nations.
It could start with an international coalition to protect a few industries, starting with the automotive or another industry that is vital for national security.
The second, by Brian Deese, an innovation fellow at MIT and a former director of the White House National Economic Council, advocates for a Marshall Plan for clean energy. This effort would consist of financing U.S. industry to aid countries most vulnerable to climate change.
We think it unlikely in today’s politics that another Bretton Woods conference would be convened to construct a coalition of trading partners.
Read more of RSM’s insights on the world economy from its global team of economists.
Just look at the turmoil around the North American Free Trade Agreement, now the United States-Mexico-Canada Agreement. .
What seems most likely is for the U.S. and the European Union to cooperate by protecting and investing in industries that are vital for defense and public health through tariffs or restrictions.
Industrial policies that invest in domestic industries are, in one sense, a transfer payment from the government to the workers in that industry, who then pay taxes on their income.
Take Nippon Steel’s proposed acquisition of U.S. Steel, which the Biden administration moved to block. In our estimation, this type of economic cooperation between allied nations will become more prominent, not less, under the emerging dollar bloc.
It seems clear that U.S. defense relationships between critical allies like Japan and the U.K. would evolve as a security complement to the underlying economic logic of an emerging dollar bloc.
Nonetheless, there will be a cost to setting tariffs on goods from China. Tariffs are eventually levied on consumers who buy the protected product at a higher price.
And then there is the indirect cost of tariffs, which is equal to the cost of the more expensive domestic item versus the cheaper version made in China.
Finally, there is the lost time in waiting for corporations to gear up producing products when they could have been bought from China.
The Draghi report
The Draghi report calls for an industrial plan for decarbonization and increased competitiveness.
The report acknowledges that the era in which the European Union relied on Russia to supply cheap energy and China to make cheap goods for consumers has ended.
The Center for Strategic and International Studies, in analyzing the report, writes that the European Union needs to rethink its growth model and that Draghi’s detailed proposals offer a roadmap for the next five-year term of the European Commission.
The Draghi report supports an extensive industrial policies program, naming three factors that should be addressed.
Improve research and development. Europe must close its innovation gap with the U.S. and China, especially in advanced technologies. A big reason for this lag is that regulations get in the way, the report finds. Innovative companies that want to scale up in Europe are hindered at every stage by inconsistent and restrictive regulations. As a result, many European entrepreneurs seek financing from U.S. venture capitalists and scale up in the U.S.
Develop a joint plan for decarbonization and competitiveness. The European Union is a world leader in clean technologies like wind turbines, hydrogen and other low-carbon fuels. But Chinese competition is becoming acute, pitting the EU’s private sector against China’s combination of industrial subsidies, rapid innovation, control of raw materials and ability to produce at continent-wide scale.
Reduce Europe’s dependence on other nations. These dependencies are often two-way; China relies on the EU to absorb its industrial overcapacity and Europe relies on its handful of suppliers for critical raw materials. Most of global semiconductor wafer fabrication capacity is in Asia. If the EU does not act, it becomes vulnerable to coercion.
The report calls for a genuine EU “foreign economic policy” and greater integration among the EU nations. For instance, a separate report finds that the EU bond market is far less liquid than the German bond market.
And with physical threats rising, the Draghi report finds the EU defense industry to be too fragmented, hindering its ability to produce at scale.
U.S. policy considerations
The United States has a number of policy considerations in this new dollar bloc.
First, the U.S. should seek cooperation among its trading partners in setting industrial policies. For example, it should ask other nations for help in preventing China from sending parts to other countries for final assembly of its EVs as a way around U.S. tariffs.
Second, there is a cost for tariffs in terms of compensation for entities that lose out to tariffs. For example, $28 billion was given to U.S. soy farmers for market-share losses stemming from the 2018 trade war with China.
And there will be leakage. Reuters reported that at this time, the new UK government had no plans to put tariffs on imports of electric vehicles produced by China.
Finally, it is probably naïve to think that trade with Russia or China will suddenly turn those societies away from aggression and mercantilism.
The immediate goal should be to protect the workers in the auto industries in the U.S. and Europe while addressing the climate crisis. That does not preclude trading with China on other products that China already makes.
The takeaway
The democracies of the world are moving from unfettered globalism to the self-interest and pragmatism of friend-shoring and industrial policy.
We see a nascent dollar trading bloc forming out of need to protect essential industries.
We have already seen the damage done to our economies by the unreliability of China’s dominance of the global supply chain, China’s predatory trade practices, and finally Russia’s aggression. Acting in concert with our allies now is an insurance policy against a recurrence.
It is unlikely that the U.S. politics would allow for a full-fledged trade-defense coalition of nations or undertaking a Marshall Plan to reduce the impact of climate change.
A second-best solution might be for the governments to coordinate industrial policies that would avoid duplication of efforts.
The allocation of resources should be geared to the comparative advantages of each of the nations, coupled with the guarantee of free trade.
