The Costs of the Defragmentation of the Global Economy

by Joseph Joyce

The Costs of the Defragmentation of the Global Economy

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.