The fragmenting of free trade 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.
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 16.8% share of world GDP, while India has 3.4% and Russia 1.9%.
In some respects, this dollar bloc evolved out of the crucible of the 2008−09 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 displacing manufacturing in the West.
This new dollar bloc will emphasize 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 wake-up 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’s yearly trade surplus is nearly $350 billion with the U.S., almost $240 billion with the EU and approaching $60 billion with the UK.
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 are 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 cutoff of supplies.
As for China, the U.S. has turned to industrial policies like the public-private financing of the semiconductor 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 EU 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 “The Future of European Competitiveness,” his roadmap for the EU.
Clearly, one era has ended and another has begun that will be organized around far larger participation of the state in shaping economic outcomes.
Draghi’s report 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 that began with the financial crisis, a consensus has emerged among central banks regarding 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 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, national security interests and their dependence on support from the West and now, China. This group includes India, which is caught between its democratic roots and its access to Russian armaments and oil.
The split 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 neoliberal economics.
Instead of the winner-take-all philosophy that prevailed between 2000 and 2020, the global economy can 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 the economist John Maynard 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 its workers struggling with immigration.
China’s goal of cornering the market 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.
In today’s politics, we think it unlikely that a meeting like the WWII-era Bretton Woods Conference would be convened to construct a coalition of trading partners.
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 using tariffs and restrictions to protect and invest in industries that are vital for defense and public health.
Industrial policies that invest in domestic industries are, in a 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 with critical allies like Japan and the UK will evolve to complement the underlying economic strategies 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 production of products that could have been bought from China.