Probability, complexity, reflexivity & Goodhart's law (2020)

Goodhart's law states that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes”. Or more popularly: “when a measure becomes a target, it ceases to be a good measure” (Strathern). Similarly, Campbell’s law: “the more any quantitative social indicator is used for social decision-making, the more subject it will be to corruption pressures and the more apt it will be to distort and corrupt the social processes it is intended to monitor” (Muller 2018). It is also related to the McNamara fallacy, named after US Secretary of Defense Robert McNamara, which says that an exclusive focus on what can be quantified frequently misses what is important, even crucial but cannot be readily quantified (e.g. body count vs enemy morale in Vietnam war). Last but not least, the McNamara fallacy has affinities with the so-called streetlight effect (also known as drunkard’s search).

Social scientists and policy-makers need to be circumspect when devising and implementing policies on the basis of quantification and correlation. The assumed correlations may weaken or vanish or even invert, post-intervention. The quantified target variables may cease to be a good measure of the social phenomena to be influenced by the policies. This may be due to fundamental system-inherent instability or it may be due to the existence of actors adjusting their behaviour in view of changed incentives, costs and benefits, thereby changing the outcome of the policy intervention, which in turn affects expectations and behaviour and so on. Policy intervention is sometimes better conceputalised as a strategic interaction between policy-makers (via intervention tool) and the target group (and its behaviour). In international politics and game theory, this is simply called strategic interaction (Schelling 1960, Lutwak 2001). It can also be thought in the context of self-fulfilling prophecies and multiple equilibria, or even in terms of a Keynesian beauty contest. In different ways, Karl Popper, Ernst Nagel and George Soros have highlighted the problem of predictions and changed expectations affecting outcomes/ behavior in turn affecting individual or collective behavior and expectations. This notion of adjusting expectations and behaviour tomorrow due to a change in expectations today also features prominently in rational expectations theory. This general idea is sometimes referred to as (most recently and popularly) reflexivity. The affinities with Goodhart's law are obvious. (As an aside, quantum physics allows for an even more fundamental instability where the mere fact of observation/ non-observation alters/ determines what is in fact the case (Schrodinger’s cat).) This is of course not relevant to all or even the majority of policy interventions. But when it is relevant, its implications can be very significant.

Policy intervention can and not infrequently does lead to unintended consequences. Government regulation that forces drivers to wear seatbelts, for example, may lead them to drive faster. This may lead to an increase rather than the intended decrease in traffic-related injuries and deaths. According to Robert Merton (1936), unintended consequences can be attributed to (1) complexity, (2) perverse incentives, (3) stupidity, (4) self-deception, (5) weak human nature and (6) cognitive and emotional biases. An increase in traffic-accident-related deaths following the introduction of a seatbelt law may be attributed to perverse incentives. Driving faster is (seen as) less risky than before. When designing policy interventions, it is important to generate defensible and plausible hypotheses about the target group’s likely reaction function. 

Complex systems theory suggests that there are fundamental – rather than merely epistemic – obstacles to successful policy interventions. If a social system is a complex system – not all systems are complex – it is typically characterised by fundamental uncertainty (in the Knightian sense). Even if it is not, it may be prone to (1) sudden transitions (non-linearity or tipping points), (2) limited predictability, (3) large events, (4) evolutionary dynamics and (5) self-organisation. All these characteristics make it difficult and even impossible to rely on correlations to inform policy interventions. Moreover, when designing policy interventions to deal with rare and large-scale events, it may be difficult, often impossible to generate any “significant” correlation or relationship whatsoever between intervention and target variables. While a Bayesian approach may be more useful than a frequentist one, successful policy intervention often relies on deductive models (e.g. what causes world wars?) rather than inductive logic and probability. Even if a fair amount of data exists, it may be difficult to generate reliable probability estimates and correlations given the complex nature of the system that is to be intervened in.

Policy interventions typically take place on the basis of estimated, established correlations that are meant to be exploited. To the extent that causation (and policy intervention) is about nomological expectability rather than necessity, it is not surprising that correlations often weaken and vanish – given absence of necessity. Nomological expectability may be statistical in nature (Friedman 1953). That may be good enough, provided Goodhart’s law is not operative. It turns out that some phenomena are normally distributed (e.g. height), while others follow a power law distribution (e.g. Zipf’s law, earthquakes). Yet it is not obvious what type of probability distribution social phenomena that are to be intervened in should be modelled on. This further complicates successful policy intervention, even if the problem is epistemic rather than fundamental uncertainty.

A normal distribution may capture a policy variable accurately – until it doesn’t. Equity market returns may be normally distributed, especially if one excludes extreme moves. Extreme moves can and do occur in the case of herd-type behaviour (e.g. panic). If investors sell assets and prices overshoot, while falling asset prices erode capital buffers, further selling will occur. Financial market participants then behave like rioters in a riot model (Page 2018). This raises the issue of the validity versus the reliability of statistical models that seek to capture social phenomena. If the underlying, assumed model is wrong, the most sophisticated statistical analysis won’t be of much help. Estimating the wrong model accurately is less useful than estimating the right model less accurately. Monte Carlo simulations, for example, suggested that a major financial crisis should occur only once every 10,000 (?) years or so. In reality, financial crises occur much more frequently. The models were probably wrong because they were based on wrong assumptions.

All of this makes policy intervention, and especially large-scale policy intervention, a precarious undertaking – to say the least (Scott 1998). Basing policy intervention on an established correlation is problematic due to fundamental uncertainty, causal complexity and/ or reflexivity that often leads to unintended consequences. Policy intervention and especially large-scale interventions were responsible for the greatest humanitarian catastrophes in the 20^th century. Stalinist and Maoist economic experiments possibly killed as many people as the two world wars. But it is also worth bearing in mind that initially successful intervention on a smaller scale can lead to outsized catastrophe in the long-term. The use antibiotics helps address selected health issues but may create drug-resistant bacteria with possibly devastating consequences later on. This strongly suggests that policy interventions need to be conceputalised in terms of a dynamic understanding of systems (Perrow 2007) and correlations and target variable responses should be evaluated very critically and cautiously.

To the extent that some social systems are complex systems, policy intervention can prove hazardous – whether due to the limited (epistemic) understanding of, or  the fundamental (metaphysical) uncertainty of, the effects of policy interventions. Stable correlations should not be assumed to hold in light of policy intervention. The proverbial burden of proof is on those arguing that the correlations will hold. Second-round effects – both short- and long-term – should be estimated and evaluated (e.g. clearing underbrush to prevent small forest fires often leads to catastrophic forest fires later on). In the face of potential non-linearity, causal complexity and/ or reflexivity, policy intervention is far from straightforward and not infrequently ranges from precarious to hazardous in terms of outcomes (e.g. lowering interest rates is supposed to increase demand through higher investment but may actually increase household savings and reduce aggregate demand due to the lower return on assets and lower household income.)

Policy interventions need to incorporate a dynamic conceptualization of systems. This will not always lead to success, but it is less likely to end in failure than a more static approach based on the assumption of correlational stability. This is not at all an argument against government policy intervention, just a plea for greater circumspection and intellectual farsightedness. Albert Hirschman (1991) pointed out that the rhetoric of reaction seeks to shoot down policy reform by first pointing to their perversity, then their futility and finally their danger. Policy intervention can prove very successful and includes a significant improvement in human development indicators and lower levels of (intra-state) violence (Pinker 2011) to name just a few prominent examples. It is important to bear in mind that human cognition is not very adept at dealing with non-linearity and causal complexity. A more thoughtful approach to policy interventions needs to take into account reflexivity, the interactive nature of social phenomena and potential non-linearities. After all, policy interventions can be successful; but they can also be catastrophic. While aligning oneself with a libertarian or reformist-interventionist ideological position may be psychologically satisfying, it is also intellectually lazy. What is needed is a more balanced and thoughtful evidence-driven debate and a recognition that epistemic and metaphysical uncertainty are major causes of the failure of policy interventions. This recognition is extremely crucial to devising successful policies, not least in view of the major risks facing mankind (Bostrom 2011, Best 2018).

The politicisation & fragmentation of international economic relations (2020)*

The EU has declared China a strategic competitor and an economic rival. US policy towards China has shifted from strategic patience to strategic competition (European Commission 2019; Pence 2018; Pence 2019; Pompeo 2019). Economic relations among the world’s three largest economies (China, EU, US) are under strain over a number of issues, including not just trade and investment but also competition policies, national treatment, intellectual property right and so on. Relations between are complex and they are frequently characterised by a mix of cooperation, competition and conflict (Jaeger 2019). Nonetheless, a greater degree of competition and conflict is bound to be a permanent feature of international economic relations. Sino-US relations, for one, will remain under significant strain due to China’s geo-political rise and China’s challenge to US economic and technological supremacy. Moreover, hawkish China policies enjoy bipartisan support in the US Congress, while the US business lobby – traditionally a strong supporter of good relations with China – has become substantially more skeptical towards China in recent years due to concerns over market access, competition policies and national treatment. Sino-European relations will be under less strain given the lesser importance of security issues in bilateral relations. Disagreement pertaining to economic issues will nonetheless strain bilateral relations (e.g. market access, competition). By comparison, US-EU relations will be more amenable to accommodation given generally shared security interests and concerns about China. US-EU relations are experiencing friction due to US trade policies (including Huawei/ 5G), big tech, the climate and, yes, aspects of the security relationship (e.g. cost sharing). The absence of security competition and economic models that are like compared to China will make these issues amenable to solution. 

The shift towards strategic competition between the US and China will be weakening the liberal international economic order established in the wake of WWII. High politics (security) will increasingly override low politics (economic welfare) (Krasner 1978). Power, including military power, mattered greatly in shaping international economic and trade relations before WWII. Throughout the 19th century, for example, the major European powers imposed ‘unequal’ trade treaties on lesser, mainly extra-European powers or they sought (and often gained) outright political and economic control over weaker states (including their external trad) in the form of colonialism. The ‘opening of Japan’ and the various ‘concessions’ in China are just the best-known instances of Western powers’ gunboat diplomacy that forced open foreign countries and markets. It was towards the end of the 19th century that the US first sought to manage commercial competition among the major powers in the form of an “open door policy” towards China. The policy aimed to guarantee all the major powers equal access to China’s market. In the 1920s and especially the 1930s, following the breakdown of the international trade system during the Great Depression, the major powers scrambled to secure exclusive access to overseas markets through exclusive commercial treaties, prohibitive external tariffs and/ or outright territorial expansion. The threat of trade closure and intensifying security competition enhanced the role played by economic, political and military power in international trade relations (Copeland 2014). The inter-war period witnessed the emergence of inward-looking, protectionist trading (and currency) blocs as well as a precipitous decline in international trade and prolonged economic stagnation.

Japan's Greater Asian Co-Prosperity Sphere

The post-WWII international economic system, underpinned by the IMF, the World Bank and GATT, is based on a number of principles that constrain the power of the larger states. These include principles such as non-discrimination (esp. most-favored nation clause), reciprocity and enforceable commitments amongst others. The US viewed commercial rivalry as a major driver of the aggressive commercial and foreign policies of Japan and Germany during the inter-war period. (The US did not take a favourable view of Britain’s decision in favour of imperial preferences, either.) The new regime was to provide all countries with market access on equal terms (MFN) and established the principle of reciprocity, thereby circumscribing the ability of the more powerful countries to exploit their stronger political, military and economic position in bilateral negotiations. Moreover, the use of tariffs as a bargaining tool is constrained by tariff binding and/ or is confined to exceptional situations, and even then is subject to rules (e.g. anti-dumping, subsidies, national security, serious injury). 

British Empire

Neither GATT nor WTO completely neutralise the larger states’ greater relative power, of course, and the larger states did not always play by the rules (e.g. US-Japan trade dispute). However, by and large, the regime afforded the lesser states with a greater degree of protection, thereby limiting their relatively greater weaknesses and vulnerabilities from exploitation by more powerful states (Krasner 1976). By committing themselves not to exploit weaker states’ vulnerabilities, the more powerful states made it less risky for the smaller states to agree to trade liberalisation (Gowa & Mansfield 2003). Concerns about economic-political vulnerabilities continued to exist, but to a lesser degree. They were mitigated by the fact that most trade liberalisation took place within military alliances rather than between geo-political adversaries during the Cold War (Gowa 1994). Concerns continued to exist between geo-political rivals, which in part explains why the USSR (and its satellites) refused to join the Bretton Woods system, even though Moscow had attended the conference in New Hampshire. 

Why are states with larger economies generally more powerful in international trade politics? Strategic trade theory suggests that large economies can use their tariffs vis-à-vis small countries to improve their terms-of-trade. In this case, imposing tariffs is the large country’s dominant strategy. However, economies of similar size face a prisoner’s dilemma in terms of imposing tariffs. Both economies would be better off if they both liberalised their trade, but each will be better if it imposes tariffs in case the other country removes tariffs. Protectionism (defect/ defect) is in game-theoretic language a Nash equilibrium. A rules-based international trade regime – especially under the leadership of a hegemonic power – can help alleviate such concerns about ‘defection’ and make free trade (cooperate/ cooperate) more likely with the help of the principles of non-discrimination and reciprocity. In another strand of international trade economics called strategic trade theory, financially stronger governments can exploit their financial power to dominate oligopolistic (imperfect) markets and appropriate large rents with through subsidies that force the financially weaker party out of the market. Here again, GATT/ WTO rules are helpful by specifying what is allowed and by determining the degree to which trade retaliation may be used. Again this limits the otherwise unfettered power of the financially stronger country (e.g. anti-dumping duties, counter-veiling tariffs). The rules protect the weaker countries from exploitation by the stronger countries. More generally: all other things equal, a large, less open, more developed and more diversified economy is less vulnerable to trade closure and therefore less vulnerable in political-economic terms than a small, open, less diversified and less developed economy (Krasner 1976). Of course, a dependence on critical imports can even make large economies vulnerable, as does a lack of export diversification. While smaller economies benefit disproportionately more from free trade, trade openness makes them also more susceptible to political-economic pressure by larger economies. Once again, the GATT/ WTO regime constrains larger, more powerful countries thanks to non-discrimination and reciprocity. 

A weakening of the commitment to a predictable and rules-based international trade regime that constrains the power of the larger economies creates incentives for smaller and mid-sized economies to limit or at least proactively manage their trade- and investment-related political-economic vulnerabilities. For instance, China does not want to find itself in as vulnerable a position vis-à-vis the US as it did in 2017 ever again (e.g. US imports tariffs and export restrictions effectively targeting China; investment restrictions effectively targeting China; legal action against Chinese companies operating in the US). Korea does not want to feel vulnerable vis-à-vis China on account of trade or non-traded-related restrictions imposed by Beijing (e.g. Chinese visitors to Korea; K-pop groups visiting China; Korean companies operating in China). The increasing use of third-party sanctions by the US, for example, has certainly increased the reach of economic sanctions and the risk to states potentially (or actually) seen as hostile by the US. The size of the US market and the importance of US-supplied global economic and financial infrastructure (e.g. dollar) give Washington considerable reach by (ab)using what was once thought of international public goods (Kindleberger 1981). the extent practical, more vulnerable countries will seek to reduce their vulnerability with regard to more powerful, potentially hostile states. Moreover, as national security considerations become more important relative to economic welfare, the security and reliability of supply chains becomes a more important consideration even for larger economies (e.g. China’s dependence on semi-conductor imports; Japanese dependence on rare earth imports). States will seek to more actively manage their trade dependence and limit the ability of potentially hostile states to ‘weaponise interdependence' (Farrell & Newman 2019). This can be done by diversifying import (and export) markets. It can be done by switching suppliers and buyers. It can be done by producing critical goods domestically. Either way, economic efficiency will take a backseat to political considerations and concerns. This effectively politicises international trade (and investment) and its fragments the global multilateral economic regime. 

Concerns related to national security and technological leadership will override welfare concerns against the backdrop of increased security competition – at least in the case of Sino-US relations. In a world or in a game where the priority is to come out on top, states will be engaged in a zero-sum rather than non-zero sum games. High politics begins to dominate low politics (Krasner 1978). Naturally, military, political, economic, financial and ideological power has always mattered, including in post-WWII international economic relations. But states were more concerned about making absolute gains, not relative gains. However, absolute gains may be desirable in the context of amicable security relations. In the context of intensifying security competition, relative gains – including maintaining economic and technological leadership – become substantially more important. Therefore, further politicisation and fragmentation is set to occur against the backdrop of intensifying Sino-US strategic competition. A complete breakdown a la 1930s will likely be avoided (Jaeger 2019) given the significant absolute costs this would entail without, arguably, offering any substantial relative gains. Seeking to slow down China's rise by dismantling global supply chains may or may not have worked 20 years ago. The existence of extensive and complex supply chains makes it somewhere between impossible to ineffective to seek to isolate China commercially. But sectors considered strategic in terms of technological leadership and military primacy can be targeted successfully and they will be badly affected. In other words, the ‘political’ in the international political economy will become more important. This may come as more of a surprise to economists than political economists. After all, international political economy has always been about both economic and military power (Viner 1948), including during the Cold War. 

Zero-sum game competition in selected areas will lead to the further politicisation and fragmentation of the international economic system. True, the multilateral trade regime has been fragmenting for a while due to the emergence of FTAs. But this was mostly a consequence of the difficulties involved in tackling politically sensitive non-tariff barriers to trade, increasing membership size and so on. The fragmentation was due to a lack of progress in terms of multilateral trade liberalisation. Leaving aside the question if and to what extent regional trade agreements are welfare-enhancing or -reducing due to the relative effects of trade diversion and creation, FTA liberalisation is generally not outright regressive in the sense of putting up new barriers to trade and investment. By contrast, concerns about political-economic vulnerabilities and technological competition are leading states to impose market access restrictions and market access denials in terms of trade and investment. Such measures will be outright regressive from an economic welfare point of view (e.g. China government departments switching to local IT suppliers; CFIUS). In short, politicization and fragmentation will be reflected in market access restrictions, investment restrictions, IPR transfer restrictions, export controls and so. While such measures may foster greater regional integration in some instances (e.g. EU screening and competition policies), it will lead to regressive fragmentation at the global level. 

Power considerations will gain greater importance at the expense of pure welfare considerations. Liberal economic theory suggests that international liberalisation leads to a more efficient resource allocation and, typically, to welfare gains in all economies (Ricardo’s comparative advantage). And even though within economies some groups may lose out in relative and absolute terms, they can in principle to compensated thanks to the absolute welfare gains an economy experiences in the wake of liberalisation. The free flow of capital allows capital to go where it is the most productive and generates the highest returns. Foreign direct investment, and especially greenfield investment, also facilitates technological diffusion, a major source of productivity growth and economic development. (Note: The benefits of free trade may be less clear-cut if the environmental costs/ externalities are factored into the equation.) Last but not least, some liberal thinkers have claimed that free trade fosters international peace and stability, even though the empirical situation is a little more complicated (Mansfield 1994). Overall, a liberal international multilateral economic order is undoubtedly conducive to economic welfare. But the major economic powers are bound to attach less weight than in the past to economic welfare considerations relative to the broader political and security implications of their foreign (and domestic) economic policies. 

A further regionalization of the global economy is likely given the increasing politicisation of international economic relations. While the blocs would continue to engage in economic exchange with each other, it would be more limited, thereby allowing each to strike an acceptable balance between reaping the benefits of economic openness and the associated political-economic risks in case of closure. It is of course possible that the major economic powers will find a mutually acceptable compromise over how to reform and preserve the liberal multilateral order. It is far certain though that such a reform would suffice to stabilise the regime in the longer term. As long as China is seen as threatening US military supremacy and technological leadership, any regime will be inherently unstable. (Remember: from the US point of view, US trade deficits with Japan in the 1980s were high not due to Japan’s high savings rate/ US’s low savings rate, but “unfair trade practices”.) Unless a reform mitigates Chinese competition, the international economic regime will remain dynamically unstable. This is about which country will emerge as the technological leader, not whether outcomes are due to market forces or state support. This is precisely why the politicization and fragmentation will likely prove an enduring feature of international economic relations, even if the major powers manage to preserve some core elements of it.

Source: EuroStat, OECD

In conclusion, the international economic regime is to suffer from increased politicisation and fragmentation due to (1) the increasing importance of political and military power considerations against the backdrop of increased security competition, (2) rising concerns about relative rather than absolute economic gains. Furthermore, (3) trade and investment restrictions will become a more common feature, but protectionism will on the whole remain selective and targeted (e.g. technology, security) – though admittedly a lot can apparently be construed as relevant to national security (e.g. car imports from allies) and (4) governments will pursue more activist policies in an attempt to win the technological race, including support for national champions, competition policies and so on. In other words, it will be a world where power and security matters more and short-term economic efficiency matters less than in the past.

* A special thanks to the students in my Columbia University capstone workshop on trade wars. Their lively and engaging discussions have inspired this comment: Daniel Marechal, Joon Song Lee, Lukas Feldhaus, Samantha Weiss, See He Kim, Woonjae Kim, Xinyi Sun and Yuxin Huang

Germany's structural vulnerabilities in the face of weakening multilateralism (2020)

Germany is characterised by a high degree of international economic integration. This is a source of risk in view of the increasing concerns about the stability and durability of the post-WWI liberal international order (Jaeger 2020). The end of the Cold War and the integration of the Eastern European economies into the EU single market allowed corporate Germany to extend its supply chains and tap into former Communist countries’ low-cost but well-educated workforce. This not only helped lower the price of intermediate inputs in German exports. It also helped keep German labour costs down. Near-simultaneously, China’s investment-oriented growth and economic rise led to a sharp increase in demand for German capital goods exports. Last but not least, the creation of the euro locked Germany’s major trading partners into a fixed exchange rate regime and prevented the sort of competitive devaluations that had characterised Europe’s various post-Bretton Woods exchange rate regimes. Over the past 25 years, Germany’s trade openness has increased substantially and is today significantly higher than in all other major economies.

Source: World Bank

At close to 60%, the EU-28 (or rather the EU-27 and the UK) absorb the bulk of German exports. Among the top-15 trade partners, each of which accounts for 2% or more of German exports, only three are not members of the EU or EFTA, namely, the US (9%), China (7%) and Russia (2%). In other worlds, leaving aside the US and China, export concentration is very limited. This is not to suggest that trade with the US, China and Russia are not economically and politically important. It would a great exaggeration, however, to claim that the German economy is “dependent” on any of the major non-EU markets. To put this into perspective: upward of 70% of both Canadian and Mexican exports go to the US.

Source: BMWi

Total trade is a useful, but insufficient measure of trade dependence, let alone economic dependence, for it does not take into consideration the degree to which exports and imports add to economic growth, nor whether whether imports can be substituted. At 4/5, domestic value-added in German exports is about the same level as in Italy and France, but tangibly lower than in the US, Japan, Brazil and China (around 10%) as well as China and India (around 15%) (OECD 2020). The importance of trade to German prosperity is most starkly reflected in the fact that 28% of German jobs are directly or indirectly linked to trade. The respective figure for the manufacturing sector is a stunning 56% (BMWi 2019). Last but not least, the German economy, like many other economies, is dependent on critical commodity imports, including energy. This latter fact explain why the German government has historically been prepared to defy US diplomatic pressure over its import diversification strategy (incl. Nord Stream 2). All said, there is no doubt that the German economy is quite susceptible to external trade shocks given the high degree of trade openness. But its trade profile is more robust than it may at first appear thanks to the large share of EU (and euro area) trade and a fair degree of overall diversification and a slightly higher share of import content in its exports compared to several of its peers. Naturally, in the event of a major global shock, trade diversification is not of much use.

Germany’s de facto international financial integration is high and its net foreign claims have surged dramatically in the past few years on the back of very large trade surpluses. The net international investment position has risen to 70% of GDP compared to less than 5% of GDP a decade and a half ago. The German government usually argues that the trade surplus is not an economic-political issue because its size, shape and form is due to market forces. Whatever the merits of this argument, large gross and net external claims make the economy more susceptible to international financial volatility and losses (e.g. German Landesbank losses on CDOs in 2008). Moreover, the financial returns on foreign asset holdings are very low (IFWK 2019; Jaeger & Mayer 2013), suggesting (but not necessarily proving) that the huge surplus savings (aka current account surplus) would be better invested in the domestic economy rather than exported. To get a better grasp of how significant these financial risks are, a more detailed geographic and sectoral analysis would be required, which unfortunately is beyond the scope of this comment. Just for reference, FDI accounts for EUR 1.5 tr and and portfolio and other investment for roughly EUR 3.0 tr each, with financial derivatives and reserve assets accounting for the remainder of foreign asset holdings. German gross assets increased from just over EUR 2.0 tr (< 150% of GDP) in 2000 to EUR 8.5 (>250% of GDP) in 2018. (By Q3-2019, assets had surged to an all-time high of EUR 9.6 tr.) By comparison, US foreign assets amounted to less than 150% of GDP in 2019. The upshot is that Germany’s large foreign assets, often seen as virtuous, also create financial risks or at least sensitivities - maybe outright vulnerabilities.

Source; EuroStat

In terms of outward FDI, the EU accounts for 1/3 of Germany’s outward FDI stock, followed by both the US and Asia with 1/4 each. Compared to trade, outward FDI is less heavily concentrated in the EU. Both the US and Asia are more important in terms of German outward FDI than in terms of German exports. It is worth noting that Germany trades with, and invests in, the US and China in comparable measure, at least as far FDI is concerned. Two decades ago, China was not even on the proverbial map. The longer-term implications of this trend are worth exploring in a separate comment, not least given that China’s share in German exports has almost quadrupled since 2000 and is set to increase further on current economic trends. German FDI in China increased similarly. Increased trade with, and investment in, China makes Germany structurally more reluctant to confront China by threatening to restrict trade, quite apart from the fact that generally such measures are WTO inconsistent. (The US fewer qualms given its more limited trade relationship with China.) Again German outward FDI is relatively well diversified, even though the non-EU share is much larger than the non-EU share of its exports.

Source: BNP

The post-WWII international multilateral economic regime and ever-closer European economic integration have allowed Germany to reap the benefits of increased international trade and investment. De-globalisation would put these benefits at risk. Should the present multilateral economic order falter, the EU single market would provide Germany with a second line of defence. At this point, a complete and permanent breakdown of the WTO should probably be considered a tail event in spite of the current US administration’s attempts undermine it by not blocking the appointment of judges to the appellate body. A future US administration is likely to be less unilateralist and more keen to reform the WTO rather than weaken the WTO further. There is reason to be somewhat optimistic. While Germany, given its greater trade dependence, does have a greater stake in the maintaining a liberal and stable international order than the US, Berlin (and Tokyo and Ottawa and others) shares several of Washington’s concerns and grievances as far as China is concerned (e.g. IPR, industrial policy, China 2025, China market access). Berlin, not surprisingly, opposes the means by which these ends are being pursued by the current US administration. Resorting to economically damaging tariffs and invoking, rather dubiously, various types of exemptions under WTO rules risk undermining the WTO framework. This is not in Berlin's interest. Nevertheless, Berlin is concerned about the “competitive” threat China poses to key German industries and technological leadership. Berlin has already introduced tighter investment restrictions in sectors deemed "critical". The new inward investment regime will also allow for more thorough screening of non-EU investors in various high-tech sectors (Financial Times 2018). China’s state-capitalist system and practices are seen as a threat to German industrial leadership. No wonder Germany is one of the most vocal supporters of a EU-China BIT as well as the European Commission’s greater involvement in screening FDI from outside the EU. In short, Germany - like many other advanced economies -shares many of Washington's concerns and this should allow it to salvage the WTO regime from wreckage provided a mutually acceptable compromise with Beijing can be found.

Finding international agreement on how to reform the WTO will prove politically difficult and it will take time before a compromise on broader WTO reform is reached. In the meantime, Germany might be well-advised to put its trade and fiscal surpluses to work. Designing a long-term, productivity-enhancing investment programme focused on developing key future technologies might offer a temporary fix to cope with a skewed level playing field. Selling fiscal stimulus policies to the German government is difficult task (Jaeger 2019) given Germany’s experience with Keynesianism in the seventies (and given its ordo-liberal beliefs). But the German government has become less hostile towards increased spending in the context of an investment programme. As with all industrial policies, there is the question of whether and how to design a successful and efficient programme. 

Undoubtedly Germany has significant fiscal space and faces no external financing constraint in terms of increasing government (or government-supported) investment by 1.0-1.5% of GDP annually. (Additional spending of that size would not violate the constitutional "debt brake" as of now. The challenge is rather how to design efficient spending plans and implement them effectively.) The fiscal position, including the structural fiscal deficit (surplus, in fact), is very strong and government debt is set to continue to fall for the foreseeable future. Germany’s trade and current account surpluses are huge and would not represent any obstacles whatsoever in terms of raising investment. In fact, reducing Germany’s net foreign claims might even help reduce the risks associated with too rapid an accumulation of foreign assets. Once again, the key question is whether boosting investment makes economic sense. Can investment projects be found whose economic (and social) returns exceed the cost of capital (currently negative in nominal terms)? Can the programme be designed in a way so that it does not contribute to domestic cyclical overheating and a build-up of financial risks?

Source: IMF

In the security realm, post-WWII Germany relied on the US and NATO, while seeking to strike the right balance between its European and transatlantic interests in the context of its commitment to Westbindung (even during Willy Brandt’s Ostpolitik). As in the case of the international economic order, Germany is increasingly concerned about Washington’s longer-term commitment to the transatlantic security alliance. NATO and the US were indispensable in terms of security during the Cold War. GATT and European economic integration were indispensable in terms of economic prosperity. With US support for the multilateral economic order in doubt and with China emerging as a potential economic competitor, Germany will seek to strengthen the EU economically. With a US commitment to NATO that looks less solid than before, Germany will seek closer security cooperation with France. Ultimately, the US is unlikely to abandon NATO. After all the US had to intervene in Europe in two world wars and one cold war during the 20th century in order to prevent the continent from falling under the hegemony of a single country. (This observation will understandably do little to put the Germany security establishment at ease.) Rather than the emergence of great power competition between the world’s three major economic blocs, we are more likely to see North America and Western (and Central) Europe maintain a security community (Deutsch 1957) – at least for the foreseeable future. There is going to be a continued tussle over the distribution of the costs of maintaining the military alliance. But this is hardly a new phenomenon (Olson & Zeckhauser 1966; Zimmermann 2002). Germany, more than most other countries, has a keen interest in preserving both the multilateral liberal economic order and the Western multilateral military alliance. Cognisant of its structural vulnerabilities, Berlin will go a long way to seek to find a compromise with Washington that will help preserve the foundations of Germany's post-war economic stability and security.