Interconnections in a Fragmenting Global Economy

Despite talk of deglobalization, despite the rise of armed conflict and hostilities in the Ukraine and in the Middle East, the world economy remains deeply interconnected. All nations are dependent on international trade and investment.  Economic self-sufficiency is not an option for any nation regardless of size. 

The world is not de-globalizing but the economic interconnections among nations are becoming more fragmented and are being re-configured along geopolitical and regional lines. Geopolitical proximity is becoming more important than geography for foreign direct investment flows. The United States, the second largest trading nation after China, and the champion of globalization, has embraced onshoring, near-shoring and friend-shoring of production for several interrelated reasons: to strengthen the resilience of supply chains, to increase national production and employment, to maintain a lead in key foundational and dual-use technologies like advanced semiconductors and artificial intelligence, and to respond to both the competitive threat and the national security threat posed by China’s rise as a major economic and military power.

There is a growing division of the world’s economies into competing blocs in ways not experienced since the Cold War. Three blocs are emerging–countries that are China-leaning, countries that are US-leaning, and non-aligned countries trying to act as economic connectors among the other two blocs. 

According to the International Monetary Fund, the fragmentation of the global economy could reduce global GDP by 7%.  According to the WTO, new trade restrictions have tripled since 2019, and the separation of the global economy into two blocs, a US-led bloc and a China-led bloc could reduce global GDP by 5%.

The era of growing globalization between 1960 and the onset of the Global Financial crisis in 2006-2007 reflected a positive sum belief—that globalization—that open markets, trade and cross-border flows of physical, intangible, and financial capital would produce net benefits—that all nations would be winners.  It was also based on the belief/hope that welcoming China, the ascendant economic power, into international rules and institutions would drive its evolution from a socialist market economy to a democratic market economy.

There were many benefits of this era: poverty reduction and the rise of the middle class in China and other emerging markets, the convergence in growth rates among countries and regions, low inflation and falling interest rates, and a reduction in inequality among nations.

But not everyone benefited.  In the US and other advanced industrial economies, many middle-income, middle-skill workers especially in manufacturing, faced competition from low-wage workers in China and other parts of the world as lower foreign labor-costs motivated companies to invest in foreign production and to build global supply chains.  On average the share of middle income households declined, particularly in the US, income and wealth inequality increased, and intergenerational mobility decreased. The share of middle class incomes in overall incomes and compared to upper-income households declined.  The middle income groups grew smaller across generations: close to 70% of baby boomers were part of the middle class in their twenties compared with only 60% for millennials. Incomes for the middle class stagnated  or grew much more slowly than the incomes of the top 10% for more than a decade. The costs of a middle class lifestyle, including the cost of housing which is the single largest spending item for the middle class, increased faster than inflation. The deep global recession in 2007-2008 and the slow recovery through 2019 exacerbated these trends.

A growing number of middle class citizens and voters in democratic market countries began to question the benefits of global interconnections, believing that low-wage competition, often unfairly subsidized by China and other foreign governments, was harming them and their countries. Their skepticism extended beyond trade to immigration. Popular support for globalization declined and tariffs and other trade barriers began to proliferate.

In the US, the passage of the North American Free Trade Agreement (NAFTA) in 1994, generated rising fears of cheap imports from Mexico, and Trump ran on and governed on fears of immigration from Mexico and fears of cheap imports from China.

Worsening economic conditions eroded trust in government and democratically elected leaders for their failure to protect them and fueled the rise of right wing populism. According to a 2023 survey, the share of a country’s population trusting its government is over 50% in only two European countries, the Netherlands (55%) and Sweden (54%)  and is 42% or less in Germany (42%), Italy (42%),  the US (40%) and France (39%).

Voters and populist leaders often blame globalization for their economic difficulties. But technological change and the digitization of production have been much more important. They have changed the composition of employment, triggering a decline in the share of middle skill/wage  jobs as a share of total employment and an increase in both low skill, low-wage jobs and high-skill, high wage jobs as shares of employment.  Middle skill jobs have been hollowed out, wages for middle skill jobs have grown slowly or stagnated and labor markets have polarized. Moreover, the digital revolution in technology has turbocharged globalization, enabling the creation of complex supply chains and the migration of  production and employment to China and other emerging market locations.

An unanswered question for the future is whether AI, the newest technology, will have similar adverse effects as the digital revolution, on work, on workers, on  the middle class, and on economic and political stability.   There is reason for optimism that AI could significantly boost productivity growth.  But there are reasons for concern about the transitions/disruptions in work, occupations and skills that will be necessary, about how workers will be supported during these transitions, and about how the resulting productivity benefits will be shared between capital and labor and among different workers at home and around the world.

AI is a general purpose technology.  It will affect what is produced and how it is produced in every sector from agriculture to manufacturing to services. It is a technology that can be deployed in ways that benefit the world–for example, by accelerating the pace of scientific discovery, by improving the diagnosis and treatment of disease, and by helping to tackle climate change. But it is also a technology that poses national security threats–threats to national defense systems, cybersecurity attacks, privacy attacks, misinformation and attacks that undermine trust and affect political outcomes in open democracies.

Semiconductors, a key input into AI models, is one of the sectors behind the industrial policies embraced by the US and Europe during the last several years in response to China’s ascendance as a major economic and scientific power. Semiconductors, critical minerals and batteries–all industries targeted for market dominance by China–provide essential inputs for digital and green industries in the US and the other advanced industrial economies.  The US and its allies are right to respond with policies to keep global markets competitive, resilient and secure for these key products and technologies. 

But coordination among the US and its allies is necessary for effective industrial policies for many reasons — to avoid a costly tit-for-tat subsidy or tariff war, to avoid duplication and excess capacity, to achieve scale economies and cost reductions in products and services and to accelerate scientific and technological progress.

Russia’s invasion of the Ukraine has strengthened cooperation among the US and Europe to meet a shared challenge to the rule of law. Cooperation and coordination are also warranted to meet another shared challenge–growing economic and technological vulnerability to China.  We must strengthen our collaboration in basic science. But we must move beyond basic science to engage with our companies in problem-solving pre-competitive R&D and applications of new scientific and engineering knowledge.  An important area for such market-facing, market-creating coordination is climate change. Both the US and Europe are committed to net zero goals and have introduced ambitious industrial policies to achieve them. But to date they have failed to coordinate them, undermining their effectiveness and creating frictions and trade barriers among allies. Today’s leaders in the US and other democratic nations have two overarching obligations to their younger generations: to protect democracy and to create a sustainable climate.  Today’s leaders must work together first, to defend democracy and markets by protecting and strengthening the rule of law, both within nations and between nations; and second, to speed and scale a successful transition to a net zero future.