The puzzle of German fiscal rectitude (2019)

The New York Times and the Financial Times have criticised Germany’s reluctance to adopt an expansionary fiscal policy in the face of a weakening global economy. With the effectiveness of monetary policy in doubt, they argue that fiscal policy is even more than important than ever to counteract what appears to be an intensifying economic downturn that risks morphing into prolonged (secular) stagnation and deflation. Given that Germany is not only the largest economy in the euro area, but also the economy with the largest fiscal space, international commentators find it difficult to understand Berlin’s reluctance to go for a fiscal stimulus. They find this even more incomprehensible in light of the fact that the export-oriented German economy appears to have been more affected by weakening global economic conditions than other large economies. The German economy seems poised to tip into recession.

Germany has historically been more reluctant than many other countries to resort to counter-cyclical fiscal policies (aka Keynesian demand management). During the euro area crisis, Germany resisted expansionary fiscal policies that would have helped provide a much-needed stimulus to the peripheral euro area economies. This effectively increased the adjustment burden on the peripheral crisis economies. In the terminology of Charles Kindleberger (1973), Germany acted as a ‘lender-of-last-resort’ by offering financial support. But it did far less to "open markets to the distressed countries" in the sense of generating additional demand for the peripheral economy exports than it could have done. Germany deflected the burden of macroeconomic adjustment and stuck to its macroeconomic policy preferences.

Compared to other countries, Keynesianism’s popularity in Germany was short-lived. In the late 1960s and early 1970s, the German government under the leadership of Finance Minister Karl Schiller resorted, to but quickly abandoned a demand management oriented fiscal policy (so-called Globalsteuerung). The Keynesian experiment came to an end with the first oil shock and economic stagflation. This experience has contributed to Keynesianism’s lack of popularity ever since. Besides the historical experience, there is perhaps also an economic argument that limits the popularity of Keynesian policies. In an export-oriented, open economy with an independent central bank, fiscal stimuli tend to be less effective than in less open economies where the central bank acts in a more accommodating manner (Scharpf [1987] 1991). Admittedly, lack of monetary accommodation is probably not something the German government should be worrying too much about at the present moment.

Financially speaking, Germany can certainly afford a limited fiscal stimulus - and certainly a time-limited one. At less than 60% of GDP, Germany’s government debt burden is low by international standards. The ratio compares very favourably to the US (106%), the UK (87%), France (99%), not to mention Japan (237%). Unlike in the other major economies, it has also been on a downward trajectory since after the global financial crisis thanks to a small fiscal deficit and decent economic growth. Gross government debt fell from 81% of GDP in 2010 to just below 60% of GDP in 2018 and it is set to fall below 50% of GDP by 2022. Few, if any, of the other major economies are projected to see their debt ratios decline in the medium term. If that weren’t enough, Germany has also one of the lowest interest rates in the world, besides Japan and Switzerland. The German government has just issued 30-year debt at a negative yield. Provided the government can identify investment projects that are sufficiently profitable to repay the principal, increasing public investment would seem to be a no-brainer. 

Source: IMF

Germany does face large implicit pension and health-care related liabilities due to a rapidly aging population– more so than the other major economies. The IMF puts the net present value of pension and healthcare spending at respectively 40% and almost 50% of GDP during 2015-2050. This is a relatively large amount. It therefore makes good sense to maintain a strong fiscal position. However, a temporary fiscal stimulus worth 1-2% of GDP won’t make much of a difference in terms of the long-term health of public finances. The key term here is temporary. Keynesian fiscal policy foresees that the stimulus be withdrawn once economic activity returns to potential. But even if Germany decided in favour of a permanent increase in spending or decrease in revenues of 1% of GDP, this would keep the debt ratio on a downward trajectory over the medium term. Germany’s cyclically-adjusted or structural budget balance was 1.2% of GDP (surplus) last year and is projected by the IMF to remain above 0.5% of GDP. Assuming modest) nominal GDP growth of, say, 2%, Germany could easily provide 1% of GDP worth of stimulus, even permanently, and the debt ratio would continue to decline. All of this is to say that Germany could afford a fiscal stimulus – especially a temporary one.

Source: IMF

Critics find Germany’s reticence to loosen fiscal policy all the more puzzling given allegedly large infrastructure investment needs. Why not borrow at no cost and upgrade Germany’s supposedly deteriorating infrastructure? It is less obvious that it may at first appear that (1) Germany is in need of significant (public) infrastructure investment and that (2) the government is well-placed to identify sufficiently profitable public investment projects. Interestingly, liberal economists are typically quite skeptical about a state’s ability to pursue a successful industrial policy and yet they want the German government to increase investment spending significantly. Critics contend that Germany’s investment needs are tremendous, ranging from broken bridges, a decrepit railway system and a digital and technological infrastructure that is severely lagging. Germany would no doubt benefit from upgrading its infrastructure, especially in light of its Industrie 4.0 targets. But it is also worth putting things into perspective. Germany ranks number in terms of the World Bank’s Logistics Infrastructure Performance Index. So identifying investment projects with high financial and social returns may be more difficult that is sometimes suggested. After all, repeated Japanese attempts to drag the economy out of stagnation and depression arguably yielded little – even though how successful or unsuccessful these policies were depends on one’ counterfactual – in terms of short- and long-term growth. This argument is debatable, admittedly. However, as far as large-scale infrastructure investment is concerned, it is advisable to proceed carefully. 

Naturally, a fiscal stimulus does not need to rely on public infrastructure investment and is actually bound to be more effective in terms of its counter-cyclical impact if it focuses on consumption. Counter-cyclical fiscal policy should be timely, targeted and temporary. Investment often requires significant lead times, while a consumption-oriented stimulus generally kicks in more immediately, especially if it is time-limited. It is also easier to set and credibly commit to such a time limit, compared to investment projects whose costs and length are often difficult to predict with much precision. Germany did exactly that in response to the global recession following the global financial crisis in 2008-09. The so-called cash-for-clunker scheme successfully supported domestic German demand and more specifically the German car industry in a timely, temporary and targeted way. None of this is to suggest that Germany would not be well-advised to examine very closely ways to boosting infrastructure investment. But there may be more cost-effective way of going about providing short-term support to the economy. And if fiscal space is meant to do more than provide a temporary stimulus, the government should draw up investment plans and funding, perhaps involving private-sector participation to make them more effective and less costly for the government. While an investment-focused (deficit-financed) spending programme is desirable from a longer-term productivity and growth perspective, a short-term stimulus will be more effective from a short-term stabilization point of view.

Is there then an economic rationale for not deciding in favour of a fiscal stimulus? At present, German unemployment is near all-time lows and labour participation is very high. Granted unemployment is a backward-looking indicator. But the urgency of a fiscal stimulus is limited from a political perspective. The German government also seems to be uncertain about the economic outlook and about how temporary or prolonged or severe the economic slowdown will be. The Fed, for example, is facing a similar dilemma. Until recently the US data looked reasonably solid, but the markets and commentators were increasingly negative on the outlook and forced the Fed into policy easing. Moreover, the German budget has significant built-in automatic stabilisers, making discretionary measures less necessary and urgent than in countries with smaller budgets and/ or fewer fiscal stablisers (e.g. United States). Then  there is the issue of getting the timing right. The economic indicators arguably are sending somewhat mixed signals (or did) and the German government may consider it premature to open the fiscal tabs, or turn on the fiscal tabs, but then the slowdown proves temporary. Last but not least, fiscal stimulus policies tend to less effective in a very open economy (low fiscal multiplier due to leakage of domestic demand abroad). A coordinated fiscal expansion would be more effective, but this would run into German political concerns about loosening hard fought for constraints on euro area member fiscal policies. None of these arguments points to a complete ineffectiveness and political unwillingness to move towards a looser fiscal policy stance. But they seem to make it more justifiable to proceed cautiously and sensibly. 

What are the political factors accounting for Germany’s greater fiscal restraint? First, the German constitution puts limits on fiscal flexibility, more specifically the size of the fiscal deficit (so-called Schuldenbremse). (The constitutional provision should perhaps best be seen as a reflection of Germany’s cautious attitude towards Keynesian policies rather than as the source of Germany’s restraint.) Second, the present (like the previous) finance minister is reluctant to abandon the commitment to the so-called “black zero” (no deficit) – or is at least reluctant to abandon it if that can avoided. Acting too rashly is not a desirable choice. Third, ordo-liberalism has always had a strong foothold in German economic thinking and culture. Given the uncertainty that continues to attach the economic outlook, this also helps explain German caution. The commitment to ordo-liberalism makes Germany not only – rightly or wrongly – skeptical about discretionary market intervention and policies. It also makes German policymakers less certain about their ability to get the timing right. Once again, none of this suggests that a fiscal stimulus won’t be forthcoming. Just that German policymakers are more cautious and that the political consequences of slower economic growth have been negligible so far.

It made sense to resist fiscal expansion during the euro area crisis when Germany’s economy was operating at close to full capacity in order to save fiscal space for the next downturn. We may now be witnessing this very downturn. Should the economic outlook deteriorate further and, in particular, should labour market conditions deteriorate sharply, Germany is very likely to move towards a modest fiscal stimulus. Germany is more skeptical about the usefulness and effectiveness of demand management policies for historical and economic reasons. A strong political commitment to fiscal rectitude - strengthened recently in the context of euro area governance reform - also makes the German government more reluctant to shoot - or to be seen to shoot - from the hip. Nonetheless, Germany will in the end recognize that it is in its self-interest to opt for a modest degree of fiscal expansion. It did so in 2009 and it will do so again should the economic situation deteriorate further. For all the reasons analysed above, however, German policymakers are and will remain reluctant or - if you will - cautious Keynesians.

US Treasury names China a currency manipulator - so what? (2019)

The Treasury has designated China a ‘currency manipulator’. The last time the Treasury has named a country a currency manipulator was in 1994 (China). The recent decision was a surprise, for the Treasury must have changed the criteria it uses to establish currency manipulation. The decision appears to be politically motivated. This is supported by a Washington Post article that says that the White House put significant pressure on the Treasury to name China a currency manipulator.

Two statutes regulate the issue of currency manipulation. US legislation pertaining to currency policy consists of (1) the Omnibus Foreign Trade and Competitiveness Act (1988) and (2) the Trade Facilitation and Trade Enforcement Act (2015). As recently as May 2019, the Treasury assessed currency manipulation on the basis of three criteria it had established pursuant to the 2015 legislation For a country to be designated a currency manipulator it needs to meet all of the following criteria. It must:

1. Run a substantial bilateral trade deficit with the US defined as exceeding USD 20 bn 
2. Run a current account surplus in excess of 2% of GDP 
3. Engage in sizable one-sided currency intervention translating into net FX purchases larger than 2% of GDP (previously 3%) 

China only seems to meet the first of the three criteria at the moment. As Brad Setser points out, the Treasury may have followed the 1988 Omnibus Act, where currency manipulation is not defined numerically, rather than the 2015 statute, and this gives the Treasury more leeway. Alternatively, the Treasury may have changed or adjusted the criteria it uses to assess currency manipulation. Either way, the decision undoubtedly points to the increasing politicization of the assessment process.

Source: IMF

Designating China a manipulator is economically problematic. First, China’s equilibrium exchange rate is not significantly mis-aligned and the current account is close to balance. So China does is not manipulating its currency in order to keep the RMB artificially undervalued. True, China does run a large bilateral trade surplus with the US. But economically this is a fairly meaningless measure. Even if bilateral (rather than global) trade balances mattered in economic terms, China’s contribution to the overall US trade deficit is far smaller in (economically relevant) value-added terms than in dollar terms. The lack of logic of focussing on bilateral balances becomes readily apparent if one imagines what would happen if all countries sought to reduce their individual bilateral trade balances to close to balance. 

China does have greater control over its exchange rate than many other countries. Capital controls, tight oversight of the on-shore FX markets, dealers and financial institutions combined with USD 3 tr worth of FX reserves do give the Chinese authorities significant influence over the RMB and allow China to operate a managed exchange rate. China’s exchange rate was undoubtedly undervalued a decade or so ago when its current account surplus reached 10% of GDP. To the extent China has sought to influence its exchange rate more recently, however, it has sought to prevent excessive currency weakness (e.g. 2015). Politically, this makes sense because a sharp currency weakening would have further inflamed the trade conflict. Admittedly, it is not for the Treasury to opine on whether a large bilateral surplus warrants the currency manipulation designation. The legislation says it does. It is obviously also possible to say that an economy with a managed exchange rate manipulates its currency. But it is difficult to make sense of the Treasury’s decision on the basis of the conditions it established pursuant the 2015 Act.

Source: IMF

Naming China a currency manipulator will not help Washington prosecute its trade war against China more effectively. The statute(s) do oblige the Treasury to take remedial action in case another country runs “significant bilateral trade surpluses with the US” and they demand that the Treasury start negotiations with the designated manipulators. The 2015 legislation is a little more concrete in terms of the actions to be taken and the sanctions to be imposed. These (1) denial of financing/risk insurance on new investment (in China) through the Overseas Private Investment Corporation; (2) denying (Chinese) firms access to the US government procurement market; (3) seeking additional IMF surveillance; and (4) taking into account (Chinese) currency practices in the negotiation of new trade agreements. The economic and financial impact of measures (1) and (2) is very modest. It is difficult to see how the IMF will take on one of its major shareholders on the issue. (It did not work last time (Walter 2014) and the prospect of signing a trade agreement appears far off and, if it happens, will of course have to address currency issues. Washington will make sure it does. 

By invoking national security, the US administration already has substantial leeway to take strong economic measures against China (Section 232, 1962 Trade Act), not to mention measures on the grounds of intellectual property rights theft and industrial policy practices (Section 301, 1974 Trade Act) and safeguards (Section 201, 1974 Trade Act). Moreover, the updated CFIUS legislation (Foreign Investment Risk Review Modernization Act, 2018) now allows for greater vetting of Chinese investment in the US and the new export control regime (Export Control Reform Act, 2018) effectively allows the US to restrict (broadly defined) technology goods exports and transfers, allowing the US to target individual Chinese companies (so-called Commerce Department Entity List). The most recent suggestion that the US administration might invoke the 1977 International Emergency Economic Powers Act (IEEP) to force US companies, theoretically at least, to stop doing business with China. The policy options offered to the US administration on the basis of currency manipulation pale in comparison to the IEEP Act. 

Some analysts have suggested that designating China a currency manipulator might be a first step towards taking more radical measures, such as counter-veiling currency interventions. Countervailing currency intervention was first proposed by Bergsten & Gagnon (2012). In order to get countries that consistently undervalue their currency to adjust, they proposed the US undertake ‘countervailing currency intervention’, that is, buying the same amount of currency that the manipulating country purchases in order to neutralize the effect of the latter’s policy on the exchange rate. Acknowledging that this policy won’t work in the case of a (relatively) non-convertible currency like the RMB, they also suggested second-best measures such as a tax on the earnings of dollar assets held by the manipulating country or even restrictions on the purchase of dollar assets altogether. If this does not work, they advocate countervailing imports duties to offset what they regards as an implicit export subsidy, namely an undervalued exchange rate. 

The snag is that the US Treasury is bound to have insufficient firepower to make good on such a threat unless the Fed can be persuaded to support the policy. The White House seems to have persuaded Treasury to disregard its own rulebook when it comes to currency manipulation. Getting it to decide in favour of countervailing currency intervention won’t be too difficult and the Treasury has jurisdiction over currency policy, including the discretionary use over the Exchange Stabilization Fund (Henning 1999). The problem is that the fund’s firepower is very small. And even if the Fed were to match Treasury FX intervention, as it has done in the past, the intervention amount would be too limited to make a significant difference to the exchange rate. First, the Fed intervenes in the FX only rarely. It bought Japanese yen in 1998, euros in 2000 and sold Japanese yen in 2011. The Fed will be very reluctant to commit to massive, potentially open-ended currency intervention targeting China It would risk undermining its crediblity and independence and might weaken its ability to meets its statutory objectives. The Fed risks triggering major international and domestic economic and financial stability by supporting such an economically aggressive policies. 

True, the size of the RMB off-shore market is small and much of it is quite illiquid and it therefore may not take much FX intervention to move prices. On the other hand, the PBoC (and state-owned Chinese banks) would seek to stabilize markets through counter-intervention and through administrative controls seeking to insulate the domestic market and stablise the external value of the RMB. This would no doubt be disruptive, not least psychologically for global financial markets. For US threats to be credible and effective, the Treasury would very likely need to the Fed’s buy-in. This seems unlikely to be forthcoming. Moreover, US policy would need to be able to impose significant economic pain on China, before China will make concessions. After all, Beijing would be loath to be seen as giving in for fear of encouraging further US pressure. So there are real question markets over US policy in terms of their technical success, their domestic-political feasibility and their international political effectiveness.

Naming China a currency manipulation may primarily reflect increasing sense of US frustration about its continued failure to coerce China into a trade agreement. The limited success of the trade war and increasing concerns that a prolonged war could tip the US and the world economy into a recession. With signs of the global economy slowing or at least becoming more fragile, in part because of trade tensions, further trade measures would weaken the US economy less than 15 months before the next presidential elections. A weakening US economy strengthens China’s bargaining position. It therefore makes sense for Washington to up the ante and make very strong threats in order to (be seen as) get to an agreement with China. 

For threats to be effective, however, they need to be credible. Brinkmanship is an important element of threat bargaining. Designating China a currency manipulator and threatening to force US business to cut ties with China are then perhaps just part and parcel of a maximum pressure campaign – a campaign whose credibility is somewhat in doubt. To the extent that the global economy is weakening and the 2020 presidential elections are approaching, the credibility of US threats is beginning to decline. This does not mean that the US is not going to make good on these threats. But if Washington wants to use threats to persuade China to come to an agreement, it needs to convince Beijing that it is serious about carrying them out. Credibility requires that carries out some of the threats (signaling). Recent US actions are casting doubt on Washington’s willingness to incur substantial economic costs in the pursuit of an agreement. The US refrained from imposing tariffs on China to the full extent threatened during the recent round of retaliation, currency manipulation does not provide the administration with new and more threatening tools to cajole China and threatening to cut economic ties with China does appear to be a bluff given the economic and political consequences this would have in the US and the political opposition it would mobilise domestically. The bottom line is that the decision to name China a currency manipulator is economically dubious. It is concerning in terms of the Treasury’s institutional independence. But it is not going to be a game-changer as far as the US-China economic conflict is concerned.

US-China trade war – what is Washington's strategic agenda? (2019)

John Mearsheimer (2004) more than a decade ago predicted that the US would seek to impede China’s rise. This is indeed what IR Realism predicts (and prescribes): the hegemonic power will seek to prevent the ascent of the rising power. This is what we may now be witnessing. China’s economic rise has been nothing but remarkable. China has already overtaken the US economy on a PPP basis, even if the US economy remains larger if measured at market exchange rates. China is also spreading its wings economically and financially. China is already the largest trading partner for more countries than the US. It has also become a major investor in many countries through the state-led/ -sponsored Belt Road Initiative. China’s defense capabilities are increasing and its naval presence is expanding. While Chinese per capita income remains well below US income, much stronger real GDP growth will continue to help narrow the gap. While China lacks diplomatic allies and feels increasingly vulnerable on account of its dependence on overseas trade, this does not diminish US concerns. The US and China confront a classic security dilemma. As Thucydides put it: it was the rise of Athens and the fear this inspired in Sparta that led to the outbreak of the Peloponnesian War. China remains on course to rival the US economically, financially and politically.

Source: IMF

Are longer-term security concerns really what are driving US trade and economic policy towards China? On the face of it, the US seeks to redress a number of economic grievances related to the bilateral trade deficit, the violation of intellectual property rights, forced technology transfer, SOE subsidies and Chinese industrial policy (China 2025) as well as limited foreign access to the Chinese market in terms of trade and investment. The US administration has resorted to a combination of higher tariffs, tighter investment restrictions and export controls as well as other measures targeting Chinese technology companies. The US administration has on more than one occasion invoked national security to justify these measures, yet it is far from clear that this is the real reason behind its policies. (In the case of steel imports from Canada or auto imports from the US at the very least, the national security justification is more than doubtful.)

Source: IMF

What are the ultimate motives and strategic goals behind US policy towards China? Three broad positions can be gleaned from public statements and policy actions. They differ less in terms of means and more so in terms of ends as well as in terms of the implications for the stability of the liberal international economy system.

First, the US may view China as a serious long-term strategic competitor and seeks to stop or slow down its economic ascent. The goal is to prevent China from acquiring advanced technologies and from dominating the technologies of the future (e.g. AI, robotics, advanced computing). This is to be achieved through a combination of supply chain disruption, limits on Chinese access to advanced US technology and policies aimed at weakening China’s ability to successfully develop such technologies indigenously by forcing it to abandon its industrial policy, protecting intellectual property rights and stopping forced technology transfer (for an interesting discussion, how far along the way to technologically dominance China is, see Lee 2018). A major assumption underpinning US concerns is that competition in these new technologies will lead to winter-take-all outcome or will at least favor China in a broader strategic sense at the expense of the United States. After all, from a security point of view, a technological edge may also translate into superior defence capabilities. If these are the concerns behind the US policy actions towards China, the international multilateral economic regime is under serious threat. Trade barriers may be raised permanently without regard for multilateral rules and cross-border FDI restrictions may lead to the emergence of a technical "iron curtain". Trade barriers will make the world and individual economics poorer and barriers to cross-border investment will slow technological diffusion and hinder global economic development. Vice President Pence and presidential advisors like Peter Navarro (and no doubt some defence officials ) seem to be viewing the world in these terms. What matters are not absolute economic gains, but a country's relative economic and security position vis-a-vis other countries. If this view prevails in Washington, it is difficult to see how a long-lasting economic conflict between the US and China and a significant weakening of the multilateral, rules-based international economic system can be avoided, for China will be very unlikely to make the types of concessions that might placate the US.

Second, the US sees China as taking advantage of loopholes in the international economic governance regime and as not offering sufficient reciprocity. In this view, China’s state-capitalist economic system allows Beijing to benefit disproportionately (and/ or unfairly) by violating the spirit if not necessarily the letter of the international trade and financial regime. Moreover, while China has ready access to advanced economies in terms of investment and technology acquisition, significant parts of its economy remains closed to foreign investment, if not de jure then de facto. In this vision, the US seeks to create a level-playing field that would translate into fairer competition and a fairer distribution of gains. If reforms can address such issues as forced technology transfer, SOE subsidies as well as market access in terms of investment and goods, the international economic system will become more liberal, allowing for more market-based competition and freer trade and cross-border investment and generating greater global welfare gains. 

Last but not least, seeing China (and other countries) as taking advantage of the US, Washington seeks to weaken international economic governance in order to gain maximum leverage vis-a-vis other countries, thereby allowing it strike "deals" that are more favorable to the US. In other words, the US is prepared to abandon multilateralism and to disregard international principles and norms in order to extract greater benefits for itself - and at the costs of the countries, including China. Bilateral trade imbalances are a particular bone of contention. The complaint charge is economically questionable, for if trade deficits matter at all, it is multilateral value-added deficits that matter, not bilateral deficits measured in dollar terms. Complaints about forced technology transfer and intellectual property rights are more serious concerns from an economic perspective, as are potentially SOE subsidies and industrial policy. The violation of intellectual property may limit the incentive to invest in innovation. Subsidies and industrial policy may allow one country to extract quasi-monopoly rents under certain circumstances. But the complaint about trade deficits smacks of domestic politicking and electioneering. By imposing tariffs on imports, governments offer (concentrated) benefits to certain US sectors (e.g. steel) while imposing (diffuse) welfare losses on the US economy as a whole, especially if the economy targeted with tariffs retaliates. Granted, getting China to buy more goods may help US exports and economic growth i the short term. But in addition to it being a violation of the multilateral, rule-based trade regime, it is at least debatable whether this translates into longer-term economic gains. Economic theory does show that a large economy can exploit its power and take advantage of the smaller country by shifting the terms-of-trade in its favour - as long as the smaller economy does not retaliate. But Beijing does not seem will to yield - and this is quite aside from the question whether China qualifies as a small economy in terms of trade theory. Last but not least, pushing China to open its domestic market to increased trade in goods and services as well as foreign investment by threatening to restrict Chinese access to US markets is good economics (welfare-enhancing) and good politics (winning support from corporate America).

If one could be certain about what the ultimate strategic goals driving US policies are, one could predict with some degree of confidence how the Sino-US economic and trade conflict will evolve. For instance, if the US is concerned about long-term economic, technological and ultimately military competition, then the policy tools it is currently deploying are not just tactical in nature, but strategic. In no particular order: tariffs destroy supply chains; tighter export controls prevent China from acquiring US technology; preventing individual Chinese tech companies from doing business in the US weakens their economic and technological position; preventing US companies from doing business with Chinese companies may force them to invest in indigenous innovation etc. 

If the US is only concerned about creating a more liberal international economic regime and greater reciprocity within it, then most of the policy tools it is currently employing are meant to get China to make the concessions necessary to address US grievances. Once the grievances have been successfully addressed, policies could be reversed. In this scenario, US policy actions are simply tools to create a more liberal and more reciprocal international economic regime. This would benefits the US, but it would also benefit from global economy as a whole. 

Last but not least, if US policies are politically opportunistic, they may be used as long as they manage to garner key domestic political support and support the short-term US economic outlook. In this case, they will also likely cease to be employed once the economic and political costs of these policies increase (e.g. US recession). On the other hand, should these policies prove successful in terms of garnering domestic political support, the US may be tempted to exploit its relative greater strength (more limited dependence on foreign trade) in order to to reach bilateral agreements skewed in its favour (NAFTA, US-Japan agreement, KORUS). This would seriously the present trade regime.

Policy actions taken thus far are more or less compatible with all three interpretations. Different individuals in the administration may have different agendas, but actions taken so far are roughly consistent with all three agendas outline. In other words, the actions taken thus far tell us little about the Washington's ultimate strategic goals. 

If the US views China as a long-term competitor, it will be difficult, actually impossible to find a compromise solution. The concessions Beijing would have to make are too great and that is assuming that there is a level of concession that would pacify the US, short of total Chinese economic capitulation. If China’s long-term economic rise continues, as is likely, we may be facing a new cold economic war. The international economic system would then probably fragment and the emergence of competing economic blocs would become likely.

If what the US seeks is a international economic level-playing-field, then the conflict is amenable to a solution. China will need to make some concessions and accept changes to the international economic regime, including greater openness to foreign investment, greater protection of IPR, reduced financial support for SOEs etc. In fact, this is something Chinese liberals and reformers would like to see. A more technologically advanced China may even have an interest in seeing stronger protections and safeguards in some areas (e.g. IPR). Abandoning support for SOEs and industrial policy might be more difficult , but not impossible to achieve. In the end, continued US economic hostility may not be a price worth paying and room for compromise probably exists, as China gradually moves away from the state capitalist model. The international economic regime would become more liberal and characterized by greater reciprocity. This is unlikely to happen overnight, but over the medium term.

If the US only seeks short-term wins aimed at extracting economic benefits for itself, the multilateral, rule-based trade regime will be in trouble - at least until the other larger countries retaliate sufficiently in order to deny the US economic gains. This is what China (and the EU) is trying to do. After all, China faces limited incentives to agree to US demands, as it may encourage Washington to demand more and greater concessions in the future. Any agreement will then be more of a truce than permanent settlement. China (like Japan) would require an ironclad guarantee that contentious issues will not be re-opened once they have been settled. On the flipside, if the US encounters sufficient opposition, it may begin to realise that a trade war among roughly equal economies wars is not only welfare-destroying, but also cannot be won if the other parties are prepared to retaliate.

How will China continue to respond to US action in the trade war? China has benefitted hugely from its integration into the international economic system over the past four decades. Inward investment, technology transfer and access to overseas markets have allowed for export-driven industrialization. The relative openness of the advanced economies to Chinese inward investment helps facilitate continued economic upgrading. More importantly, China depends more heavily on foreign trade, foreign commodities and foreign technology than many other advanced economies. This should give Beijing incentive enough to make at least some concessions in order to preserve a system that has been serving it well. Only if the US is seeking to preserve the liberal international economic regime will it make sense for China to make sufficient concessions. This would then help transform China into a “responsible stakeholder” (Zoellick 2005; Ikenberry 2008) something some policy-makers and analysts predicted long ago. In China, there are constituencies that at least support further liberalisation (aka concessions). They see China’s success as largely due to China’s successful integration into the world economy and progressive liberalization rather than state-directed development policies. They would point out that Chinese SOE are far less profitable than private-sector companies and that state industrial policies are far more likely to fail than to succeed. In the short term at least, it is unlikely that their views will prevail given greater centralization and slowing down of economic reforms under President Xi.

While the short- and medium-term risks should not be underestimated, the world economic system may yet emerge as more liberal, more multilateral and more rules-based. But this is far from certain. After all, a lot of countries support reform of the liberal international trade regime as well as the creation of a level playing field as far as reciprocal market access is concerned. The other major economic powers, including Japan and the EU (and its major member-states), are in general agreement on the need for reform. Rightly or wrongly, they are also increasingly concerned about China’s foreign economic policies. Politically, the right strategy would be to start a broad-based dialogue among reform-minded countries and then take the agreed up position to Beijing. Greater multilateralism would increase the pressure on China, but it would also reassure China that it is not at the mercy of a unilateralist, unpredictable United States. So if and when more multilateral-minded political forces come to power in Washington, the global economic system may yet emerge as more liberal and more rules-based and gain greater legitimacy in the eyes of the major powers if the international economic regime can be reformed. If, on the other hand, it is long-term fear of China that is driving US foreign economic policy towards China, then the multilateral economic system is bound to weaken further and to become more unstable. The same will be true - at least in the short to medium-term - if the US sticks to its unilateral approach aimed at extracting concessions solely meant to benefit the US rather than make the regime more liberal based on the principles of reciprocity and multilateralism. Only time will tell.

Geography matters (2019)

German foreign policy under the Nazis represented - in important respects - a continuation of the policies pursued by the Wilhelmine Empire (Dehio 1948, Dehio [1955] 2015, Calleo 1980). The so-called “security dilemma” was a major factor underpinning this continuity. States typically seek security and they seek economic prosperity. Economic prosperity is a pre-condition for security. If a state fails to achieve economic prosperity and physical security, it may succumb to competition in an anarchical state system or it may end up playing a subordinate role in it. This framework offers a useful perspective and adds to an understanding of German foreign policy. Security depends on a variety of other factors, including alliances, economic power, geography, diplomacy.

Geography is a crucial and yet often under-appreciated factor influencing a state’s foreign policy. As AJP Taylor ([1945] 2011) observed in his highly readable “The Course of German History”.

"The Germans are the people of the north European plain, the people without a defined natural frontier. Without the sharp limit of mountain ranges, except at the Alps and the Bohemian mountains, the great plain is intersected by four great rivers (Rhine, Elbe, Oder, Vistula), dividing lines sharp enough to split the German people up amongst themselves, not rigid enough to confine them within settled frontiers. There is no determined geographic point for German expansion, equally none for German contraction; and, in the course of a thousand years, geographic Germany has gone out and in like a concertina. At times Germany has been confined within the Rhine and the Elbe; at others it has blown itself out to the Pyrenees and to the Caucasus. Every German frontier is artificial, therefore impermanent; that is the permanence of German geography" (Taylor 2001 [1945]: 2).

The Baltic and North Seas to the North, the Alps to the South represent physical barriers of sorts. The mountain ranges near the Rhine to the West represent a far less formidable obstacle. And even less formidable are the rivers flowing south to north, the Elbe, the Oder and the Vistula on the north European plain. The lands east of the Elbe have historically been less densely populated and economically less advanced than the lands west of the Rhine. This explains much of Germany’s demographic, economic, political and often enough military expansion eastwards. The so-called Drang nach Osten led to a more or less steady expansion of German language and culture as well as economic and political power in the East. What began with the invitation of German farmers by Polish rulers and the aggression of military-spiritual orders in the late Middle Ages ended with the partitions of Poland in the late 18th century and the quest for Lebensraum against the Soviet Union in 1941-45. Germany’s political, economic and military collapse in 1945 led to the elimination of German influence and the German presence in region, following the expulsion of Germans from the areas east of the Oder-Neisse line, territorial losses and loss of sovereignty. With the end of the Cold War and German re-unification, Eastern Europe once more opened up to German political and economic influence. The demise of the bi-polar order and the economic and political integration of much of Eastern Europe into the EU and NATO have allowed some geo-graphic and geo-political continuities to re-assert themselves.

Northern European Plain

Geography also matters to the extent that contemporary Germany traces its lineage back to Prussia, a state that emerged on the Northern European plain. Its geographic position had a significant influence on the kind of state that Prussia and later Germany would become. Neither Prussia nor the German Empire had the benefit of being protected by natural barriers to its East or West. It is therefore not surprising that Prussia and later Germany was characterised by a relatively strong and efficient state capable of mobilizing (initially) scarce resources in order to withstand competition. Prussian militarism and a so-called garrison state were pre-conditions for Prussia’s geopolitical survival, if not the only ones. Mirabeau is said to have observed that “Prussia is not a state with an army, but an army with state”. Nationalism may eventually have led to the emergence of a unified German state. As it happened, a militarily successful and aggressive Prussia unified Germany under its leadership in 1871. In other words, Germany’s geographic and geo-political position favored the emergence of a successful and military aggressive state due to strong ecological-geographic pressures.

Europe’s political centre had more of than not been fragmented and weak. This occasionally turned it into Europe’s battleground, most importantly during the Thirty Years’ War (1618-48), which devastated large parts of Central Europe, including Germany. The political fragmentation of German lands and rivalry among German states had disastrous consequences. The failure of the 1848 national and democratic revolution famously led Bismarck to remark: “The great questions of the time are not decided by speeches and majority decisions — that was the error of 1848 and 1849 — but by iron and blood”. And so they were. Bismarck’s statement also needs to be interpreted of what then were deep-seated concerns in Prussia and Germany about it falling victim to outside aggression. In the early 20th century, encirclement became a popular way to see Germany’s geopolitical position, especially after Britain, France and Russia settled their major political differences.

A particularly aggressive and successful state was bound to have the upper hand once territorial consolidation got underway. Prussia’s aggressive and adventurist foreign policy almost spelt its disaster under Frederick II. Prussia might well have disappeared from the map, or at least eliminated as a European great power, had it not been for the balance-of-power working out. Prussia’s defeat during the Napoleonic wars once more threatened its existence as a great power. Subsequent fundamental reform helped lay the foundation for Prussia’s meteoric geo-political rise during the 19th century. Had Prussia failed to reform itself, it would not likely have become the power to unify German lands, at all. This shows that a strong military was not a sufficient condition for Prussia to emerge as a great power, but it does suggest that it was a necessary one.

Increasing territorial consolidation in Europe until 1918 did lead to the disappearance of many states. Its ability not just to withstand geopolitical competition (and survive) but also to take advantage of the territorial consolidation taking place during the 18th and 19th century points to Prussia’s fitness and adaptability (Pierson 2004). A strong state heavily investing in security, while not always sufficient to avoid occasional defeat, was a pre-condition for survival and geopolitical success. German warfare and military strategy can also be understood as an adaptation to geopolitical circumstances and resource constraints (Citino 2005). The Prussia-dominated German Empire emerged as the most powerful state in Europe. Unable to adapt, its Polish neighbour disappeared from the map in the wake of geopolitical competition and territorial consolidation in the late 18th century. Poland’s fate and Prussia’s relative success illustrate the evolutionary logic and the need for states (and their domestic institutions) to adapt in the face of ecological pressures (Giddens 1987, Tilly 1993). Competition was fierce on the north European plain. Again, this is not to deny that balance-of-power dynamics and diplomatic consideration were also important helping Prussia avoid a fate similar to Poland’s.

Prussia's Territorial Expansion

As territorial consolation started and the balance-of-power system failed to do its job, Prussia became more and more powerful and militarily successful. Its territory and population increased, which in turn allowed it to become more powerful and accumulate more resources and so on. (From a different perspective, one can attribute this success in part to the rise of nationalism, of course. The point is simply that the dynamics of the system favored consolidation under a militarily aggressive state.) The wars of unification led to a significant increase of Prussian power. Adept diplomacy was equally important, as was, arguably, nationalism. Once it had established its preponderant position in Germany after defeating Austria-Hungary in 1866, Prussia, supported by other German states, defeated Napoleon III’s France and the unified Germany under Prussian leadership, while excluding Austria-Hungary. This effectively established Germany as a semi-hegenomic power in continental Europe. The subsequent economic and demographic growth support strengthened Germany’s position in material, if not necessarily in diplomatic terms.

Bismarck recognised that any further increase in German power would risk jeopardising Germany’s position and security. This explains why Bismarck sought to pursue ensure that the other European powers remained at loggerheads (Kissinger Diktat), to make Germany the indispensable, balance-maintaining power in Europe. and his desire to avoid the so-called cauchemar des coalitions and especially a possible two-front war. Bismarck’s insistence on Germany being a “saturated power” and as acting as an “honest broker” can be seen as part of the same diplomatic goal. Bismarck was acutely aware of Germany’s difficult geo-political position. Forward-looking statesmen at the time understood that German reunification has upset Europe’s balance-of-power for good. As British Prime Minister

Benjamin Disraeli put it as early as 1871:

"This war represents the German revolution, a greater political event than the French revolution of last century […] Not a single principle in the management of our foreign affairs, accepted by all statesmen for guidance up to six months ago, any longer exists. There is not a diplomatic tradition which has not been swept away. You have a new world, new influences at work, new and unknown objects and dangers with which to cope, at present involved in that obscurity incident to novelty in such affairs. We used to have discussions in this House about the balance of power. Lord Palmerston, eminently a practical man, trimmed the ship of State and shaped its policy with a view to preserve an equilibrium in Europe. [ . . . ] But what has really come to pass? The balance of power has been entirely destroyed, and the country which suffers most, and feels the effects of this great change most, is England" (February 9, 1871).

Historians would reject a system-level explanation of of Prussia’s and Germany’s rise as overly simplistic. International politics, diplomacy, nationalism and a great many other factors influenced the rise of Prussia. It is also not difficult to see come up with a counterfactual where Prussia would not have become the preponderant power in Germany. But the systems’ framework does allow for interesting insights and offers a useful way to think about Prussia’s and after 1871 Germany’s rise.

The German state that emerged in 1871 largely reflected Prussia’s geopolitical success. It also inherited and even amplified Prussia’s geographic and geo-political vulnerability. Political geography also helps explain why Germany had a large land army. As a land power, Germany was forced to spend much more resources on its army and securing its western and eastern borders against other European powers, where it was now facing a revanchist France, following the annexation of Alsace-Lorraine, and a rapidly rising Russia. Skillful diplomacy might have allowed Germany to make its semi-hegemonic position manageable. After all, mange it did, if just barely, under Bismarck’s reign (1871-90). But all other things equal, Germany’s geographic position was potentially more precarious than that of any other European power. System-level competitive pressures and path dependency help offer interesting insights explaining the rise of Prussia and Germany, and more. Contrast Germany’s gee-political position with that of the other European powers at the time.

Britain with its island geography, once it had secured control over the British Isles, was able to focus on overseas colonial expansion and was not in need of maintaining a large standing army. This may also explain Britain’s greater propensity towards political liberalism and free trade and the tendency to attribute greater weight to commercial considerations than was the case in other European countries - and certainly compared to Germany’s more conservative-authoritarian political regime and more state-led economic development (Gerschenkron 1962). This also explains Britain’s long-established policy of “splendid isolation” until the late 19th century and its ultimate strategic objective: prevent the emergence of a hegemonic power in continental Europe. Such a hegemonic power would control all the resources of continental Europe and be in a position to take on the Royal Navy and subdue Britain.

France’s position was more difficult. Geographically, the only significant potential threat on the continent was an alliance of German states or, worse, a unified German state under centralised leadership. Only if Germany remained weak was France able to feel secure and perhaps be in a position to compete with Britain overseas. Looking across the Pyrenees and the Mediterranean was either unnecessary or promised little reward. Neither economically less developed Spain nor Italy posed the same potential political and military threat.

Russia had the benefit of being an oversized country geographically with immense resources. It could afford to be invaded time and again - not that this was its preference (but without out it, we would not have War and Peace). Its strategic depth saved it more than once in the past two hundred odd years. The fact that it ended up surviving the Napoleonic invasion did of course nothing to make it feel more secure. Following the emergence of Imperial Germany, it now had land borders with a demographically, economically and militarily rising unified Germany. This was Russia’s main security concern. Russia itself was modernisiing rapidly towards in the decades leading up to WWI and this raised the feeling of insecurity in Germany, certainly among its military (Cooper 2000).

A country’s geo-political position is bound to have an impact on its domestic institutions, political culture and economic development as well as its foreign and security policies. Germany’s 20th century history offers a tragic example of the importance of geography in international affairs. Geography did matter in the past and it continues to matter today - and not just in Europe.

Germany's economic, financial and soft power (2019)

Germany is the most populous member-state in the EU and the second most populous country in Europe, after Russia. It has the largest economy and occupies the European continent’s geographic centre. Financially, it is Europe’s most potent state and economy by far.

Demographically, Germany is the most populous country in the EU with a population of over over 80m. The three next largest EU countries are the UK (65m), France (65m) and Italy (59m). By comparison, Russia’s population is around 140m. Germany sits right at the centre of the intra-European ‘demographic divide’. Eastern Europe will be experiencing a continuous decline in population levels, while Western Europe will generally speaking continue to see rising population levels. Germany is projected to see a modest population decline, even if it seems equally possible that a higher level of net migration will stabilise the population at close to current levels. A flourishing economy, high wages and economic stability should continue to attract immigrants. Germany wis set to demographic lose ground vis-à-vis France and the UK and gain ground vis-à-vis Eastern and Southern Europe. If the UK succeeds in reducing net immigration, as seems to be its overriding political objective, the UK will gain less ground than projected only a few years ago. The populations of Belarus, Ukraine and Russia will decline more or less gently, and it is very difficult to see how these dynamics could be changed fundamentally, let alone reversed given the economic and political outlook for these countries.

Source: IMF

Geographically, Germany occupies the geographic centre of the EU. Historically, Germany found it difficult to manage this central position, especially security-wise. Today it is embedded in a collective defence and economic structure and is surrounded by economic and security partners to its North, East, South and West. NATO eastward expansion has effectively translated into Germany being surrounded by friendly countries. Germany has no territorial disputes with any other country. This explains in part Germany’s free-riding as far as collective defense and NATO defense expenditure are concerned.

Economically, EU eastward expansion has allowed Germany to extend its supply chains into Eastern and tap the region's well-educated workforce and integrate these countries its into industrial supply chain, while it continues to have access to the larger, more prosperous Western European and overseas markets for final demand. This has helped create an economically symbiotic relationship that benefits both Germany and Eastern Europe as far as economic growth is concerned, even if both Germany and Eastern Europe underwent painful economic restructuring. Germany has the largest economy and the largest industrial base. Germany also runs large trade surpluses with the rest of the world. Such large surpluses may be difficult to sustain, politically and economically. It also at present benefits from full employment and high living standards making it attractive for economic migrants. As Paul Krugman (1993) predicted, monetary integration has led to increased specialization within Europe and, arguably, the migration of high value-added production to the core countries.

Source: IMF

Financially, Germany is the largest creditor in Europe. It runs the largest trade surpluses. It has the smallest fiscal deficit (in fact, surplus) and lowest public debt among the larger EU member countries. While large external claims might become a vulnerability in case of a EMU break-up, Germany’s public debt position is incomparably sounder than that of any other large EU economy. The combination of external creditor position and economic size, including ability to raise money domestically and internationally has effectively given Germany a veto over the future course of euro area reform. Without German participation, the euro area and EU cannot be reformed. It does not mean that Germany always gets what it wants, but wields de facto veto power allows Berlin to prevent outcomes it does not like.

Germany has also gained a fair degree of soft power (Nye 1990) in recent decades, even more so in the wake of the emergence of populist and illiberal politics in Europe, the US and elsewhere in the world. Germany’s stead-fast, if self-interested defence of a rules-based, open international order and the defense of political liberalism domestically is part of Germany’s post-WII self-image. In spite of the recent rise of a far-right party, this is not going to change. Germany today ranks among the more popular countries in the world. While it is retable how exactly this provides Germany with greater political influence, it perhaps gives certain Germany policy initiatives a greater degree of legitimacy.