Fragmentation will most affect US-Chinese relations, where investment and trade restrictions pertaining to national and economic security will continue to tighten. Both Washington and Beijing will continue to de-risk, but not significantly decouple. The U.S. will largely rely on inward, less so outward investment restrictions, as well as tighter export in an attempt to ensure national security and maintain technological leadership. China will similarly seek to reduce its dependence on and vulnerability to U.S. discriminatory policies by emphasizing “dual circulation” (greater reliance on domestic demand) and reducing its technological dependence on other countries as well as gain leverage vis-à-vis other countries.
Protectionist U.S. foreign economic policies may kick into substantially higher gear in 2025 in the event of a Trump victory. Instead of selective measures targeting geopolitical adversaries and aiming to enhance supply chain security, a Republican administration will threaten to introduce across-the-board tariffs (with substantially higher rates on Chinese imports) and more aggressive reshoring policies. This could lead to substantial trade conflict with geopolitical foe and friends alike. But even under a Democratic administration, the open, rules-based international trade and financial regime will continue to erode at the margin.
Adverse demographic dynamics in North America, Europe and East Asia will weigh on the medium-term global growth outlook. In addition to adverse labor supply dynamics, particularly in advanced economies in North America, Europe and East Asia, which accounts for the bulk of global GDP, increasing pension, healthcare and defense expenditure will make it more difficult for governments to subsidize investment and promote economic growth. Unless new technologies, such as Artificial Intelligence, lead to much faster productivity growth, global growth will continue to slow somewhat, as a greater contribution from emerging and developing economies will not be sufficient to offset a substantial slowdown in China and a slightly weaker economic growth in the United States, Europe and Japan. Regardless, China’s share of global GDP will continue to increase, despite slower growth and its importance will continue to grow. As US protectionist policies contribute to greater fragmentation, China will seek to liberalize its foreign trade with third countries in the context of bilateral and regional free-trade agreements, while promoting the international use of the yuan.
The US economy will continue to outperform Europe and Japan, and the growth differential vis-à-vis China will narrow on account of slowing Chinese growth. U.S. real GDP growth is set to average 1.5-2.0%, compared to 1.0-1.5% in the large European economies and less than 1% in Japan. Chinese growth is set to average 3.5-4.5% over the next decade. While an AI-led technological revolution may help support economic growth, it is unlikely to raise the US growth potential substantially in the face of increasing demographic headwinds, global economic fragmentation and declining fiscal space to support investment. Politically, a major reform of federal revenues and expenditure that might free up resources to support future growth remains unlikely, and most of the impact would be felt beyond 2035. The US will remain the world’s second-largest economy in purchasing power parity terms.
U.S., European and Japanese interest rates are likely to be higher over the next decade than the decade following the global financial crisis in 2008. Higher government debt, larger fiscal deficits as well as increasing spending pressure related to climate change, defense and especially mandatory pension and health programs will translate into higher interest expenditure and weigh on domestic investment. Despite increasing government debt, the risk of financial instability will be manageable, unless the U.S. Congress purposefully forced the government into default in case it fails to raise the debt ceiling. U.S. external debt will remain high, the continued attractiveness of the U.S. economy, the U.S. financial system and the U.S. dollar will make the situation manageable, not least due to manageable current account deficits and a favorable liability structure. While the U.S. dollar will remain the dominant international currency, the RMB will continue to make inroads over the medium term.
U.S. economic growth will average less than 2% a year and, barring black swan events, the rate is very unlikely to accelerate or decelerate significantly over the forecast horizon. In the context of higher nominal debt and continued large fiscal deficits, debt service will increase in nominal terms, which will limit the ability to increase discretionary expenditure, while mandatory federal spending will continue to increase as a share of GDP. The Congressional Budget Office (CBO) projects both mandatory social security and healthcare spending by 1 percentage, respectively by 2033. The fiscal deficit is set to reach nearly 7% of GDP by 2023, while federal debt (held by the public) will increase by a substantial twenty percentage between 2023 and 2035, reaching 120% of GDP. The risk to spending, fiscal deficit and debt are weighted to the upside in case of domestic or international emergencies. Mandatory federal government spending, which represent 60% of total spending at present, will continue to increase as a share of GDP. Given the unpopularity of social security reform, any fiscal consolidation, if it takes place, will need to focus on discretionary spending. As interest payments on debt cannot be changed, any fiscal adjustment would disproportionately affect discretionary spending, and, given the geopolitical outlook, primarily discretionary non-defense spending.