By Philippe Waechter, Chief Economist, Ostrum Asset Management
Global macroeconomics was a formidable tool for four decades. The world was open—rather cooperative and rather coordinated. It was in everyone’s interest to be open to trade, to transfer technology and to finance investments in other regions of the world. The numerous opportunities promoted global growth and emerging countries’ incomes. By becoming a major partner of all countries on the planet, China radically changed its scope of influence. The collective improvement is today reflected in the falls of all measures of the World Bank’s poverty rate.
This period, known as the Great Moderation, resulted in growth rates and inflation figures, particularly in Western countries, marked by low volatility. In this context, central banks played key roles in ensuring the compatibility of each country’s strategies and limiting the impacts of shocks, mainly financial, without hindering overall development. Moreover, reflecting this desire for stability, they all adopted the same inflation target of 2 percent.
The management of this situation and the integration of economic dynamics were such that it was difficult to spontaneously envisage a disruption or another trajectory. During crises, and there were a few, central banks implemented considerable resources but also demonstrated solidarity between banking systems so that these upheavals were not too persistent. The economy could then return to a trajectory compatible with its course before the crisis.
The Great Moderation generated three imbalances
- Competition has changed in nature
The Great Moderation’s economy developed based on its capacity to capture opportunities all over the world. Significant technology transfers accompanied this reduction in barriers. The relocation of production only made sense if the goods produced had the same qualities as they did in their original markets.
The particularity of the period was that the primary recipient of these investments and transfers was China. Its specificity is to be large and highly populated with a considerable political will for development. A catch-up has taken place in many manufacturing sectors, resulting in China’s growing weight in developing the world’s manufacturing sector. In 2020, the Middle Kingdom (China) represented 35 percent of global manufacturing production, compared to only 5 percent in 1995.
This has resulted in the emergence of China’s incredible capacity to innovate, supported by favorable economic policies, while it has also entered into competitions with the countries that were the most technologically advanced. The phenomenon has probably happened even faster than expected. A recent ranking by an Australian scientific journal indicated that China was the leader in 90 percent of critical innovations—those that will condition the universe of tomorrow. A “terrible” shift is occurring, and a return to the past seems totally improbable. The world is going to enter a broader competition.
The rest of the world could not let such a regime change in China transpire without sharing a few reactions. The United States, under President Donald Trump and then President Joe Biden, has constrained the activities of Chinese companies in the US and US investments in the Middle Kingdom. The world is no longer a vast field of opportunities. The expansionist bias has been broken in favor of increasing local choices.
- Breaking dependency
The pandemic and the recovery have revealed an increased dependency on goods, particularly those related to technologies, such as semiconductors. Successive crises, particularly energy crises in Europe, have led to the revival of an industrial policy that had previously been abandoned. The United States responded with the Inflation Reduction Act of 2022 (IRA), while Europe is still looking for the right answer.
The need to invest in the technologies of tomorrow to avoid dependency on China has become crucial. Neither the US nor Europe wants to lose any of its possible choices to benefit China. This then results in the return of industrial policies and trade barriers, which should make it possible to define more localized strategies in line with the reappropriation of production.
The stakes are high. By defining the technological standard, the successful country will benefit from long-term income. This is a major element of the American strategy included in the Inflation Reduction Act, which provides considerable resources to companies wishing to develop locally.
Europe has been slow to define a collective strategy. A major challenge of the Draghi report (written by the former president of the European Central Bank, Mario Draghi) is to reverse priorities and put forward an innovation strategy to stay in the race.
Mastering the strategy of each region requires making choices that highlight a local dimension of innovation. The difficulty is to reverse the choices of deindustrialization made over the last 40 years, which has translated into a weighting of 12 percent for the US and 13 percent for the eurozone in global manufacturing production, while China sits at 35 percent.
- Geopolitics reinvents itself
The third point is the emergence of a political multiplicity. The model that emerged after the fall of the Berlin Wall in November 1989 did not resist the wills of Chinese or Russian leaders to define and apply their own political models. The concept of a total victory of democracy, therefore, faded rapidly.
However, globalization and emerging countries’ economic catch-ups have erased the political dimension. The densification of trade and rise in living standards have been sufficient factors to put political conflicts in the background. Germany understood this framework very well and took advantage of it to develop its exports, particularly to Asia and China.
This ancient doctrine, which considers that the improvement of living conditions through trade is a sufficient condition for maintaining peace, has worked well in Europe since the beginning of the European project in the 1950s.
On an international scale, this worked before the rivalry between China and the United States took a turn, largely linked to China’s technological catch-up. These divergences increased and took on a political dimension at the time of the Russian invasion of Ukraine, resulting in a division of the world and the definition of a new order. Thus, the Chinese and Indians did not vote for sanctions against Russia. Suddenly, an elsewhere was possible, and we saw the re-emergence of a Global South led by India, which resembled the non-aligned countries of the 1970s.
The United States and Europe have failed to maintain their grips, or at least to draw up a cooperative framework that would be democratic on a global scale. This inability also reflects the tensions within American society, which we have witnessed during the November federal elections. It also reflects Europe’s inability to influence the world due to its inability to act collectively. It is a measure of its loss of power, even though the fall of the Berlin Wall created many opportunities. This situation has contributed to accentuating the end of a form of global macroeconomic coordination.
A new and distorted framework
The three imbalances mentioned above are the consequences of the development of globalization. Incompatibilities have appeared, have gradually become greater and, finally, are now sources of ruptures.
The strong and lasting impact of these breaks is on the ability to work together. One measure of this radical change of direction was the rapid decline in foreign direct investment (FDI) in China in 2023. The Middle Kingdom was a major destination for international corporate investment. This is no longer the case, reflecting American and Chinese political choices but also the distrust of Chinese power.
The vast, open world has become more vertical. Development opportunities are no longer as attractive. Each region also wants to be able to define its own priorities and validate its choices to no longer be so dependent on others when building its future. In the US and Europe, this has resulted in the return of the term industrial policy in the vocabularies of economists and politicians. The American Inflation Reduction Act is an application of this in the United States.
These developments have major consequences:
- The world is becoming more vertical, and decisions are becoming more local. During the Great Moderation, the decisions taken reflected a form of economic optimization. Now, new constraints reduce this capacity to optimize, and decisions conditioned by local constraints can appear as second-rate.
- The more local dimension changes the hierarchy of economic policies. The strong return of industrial policy gives greater weight to government policies at the expense of central banks’ policies.
- All of this translates into the need for greater autonomy in growth. We must find local sources of growth, hence the importance of the Draghi report, which gives the keys to this autonomy to Europe via investment and innovation. The Letta report (written by former Italian Prime Minister Enrico Letta) suggested completing the construction of the internal market so that the same rules apply everywhere within the eurozone. This would make it possible for companies to benefit from scale effects comparable to those of the American and Chinese champions.
- For Europe, the complexity of this change is that it is occurring at a time when the working population is aging rapidly. It is necessary to maintain incentives for the working population to be able to increase incomes and pay pensions.
- The labor situation also raises the question of migratory flows. They are significant in the US and reduce tensions in the labor market. They are weaker in Europe, where they should increase to facilitate adjustments in the labor market by rejuvenating the active population. However, this comes up against significant political barriers.
- This demographic challenge is not only European but also arises in Asia, particularly in South Korea, Japan and China. These demographic elements reinforce the need for more local anchoring to meet the needs of the elderly population.
- The labor market will also change radically. It became globalized, thus limiting the bargaining power of employees. With a more local scale, the labor market is refocusing, giving bargaining power back to employees.
The issue of climate change
The ruptures mentioned are endogenous. The imbalances result from the way in which the global economy has developed over the last 40 years. Economies will have to adapt to a framework that has been significantly redefined and will inevitably be accompanied by tensions because interests are no longer as homogeneous and common as in the recent past. This change of regime in globalization had tumultuous effects at the end of the first globalization.
However, the framework would be incomplete without including climate change, which is not the result of globalization—even though it has, driven by China, led to a rapid increase in greenhouse gas (GHG) emissions.
The issue of climate change has several dimensions.
The first is observation. The temperature of the globe and the concentration of carbon in the atmosphere are increasing permanently, beyond historical norms. There is no ambiguity as to the anthropogenic origin of this increase.
The developments are such that speculation is increasing that the objective of 1.5 degrees Celsius (°C)—measured as a trend over numerous years above the pre-industrial average defined during the Paris Agreement in December 2015—will be exceeded in the coming years.
If this is the case, and for the planet to remain viable, we would then have to return to this objective by giving ourselves the capacity to capture a good part of the carbon in the atmosphere. The technology does not yet exist, but we must continue to innovate to meet this goal.
However, at the threshold of 1.5 °C, irreversible phenomena will occur. Frozen soils will warm up, and Greenland, the North Pole and the South Pole will see their melting accelerate. Marine currents, such as the Gulf Stream, will be disrupted. In order not to amplify these phenomena, which will already have persistent effects, every measure will have to be taken to return to 1.5 °C—continuing to innovate with the appropriate technologies.
Whatever the temperature profile, with or without adjustment to 1.5 °C, it will be necessary to reduce fossil-fuel consumption drastically. This means making specific investments in renewables and adapting the productive structure to this substitute energy. Reducing fossil-fuel consumption by 70 to 80 percent is like an industrial revolution in reverse. This is the major challenge: how to maintain well-being with an energy capacity that will be less efficient than oil and gas.
Beyond these challenges and upheavals, the management of the macroeconomy will be different. Europe and the United States are targeting carbon neutrality by 2050; in China, it is 2060. Carbon neutrality is a situation whereby the net carbon emission is zero. What is emitted is absorbed. This is an unprecedented constraint on a macroeconomic scale.
In the past, the objective was to grow quickly and over time, with the only constraint being the initial situation. From now on, our fate is linked to the convergence towards this carbon neutrality in 25 years for Europe. This means that the trajectory that we will follow is already limited and defined.
Climate change and convergence towards carbon neutrality are of a different order than the imbalances resulting from globalization. They complicate the trajectory to be followed by the global economy. The degrees of freedom are more restricted due to more vertical decision-making, and it will be necessary to reform productive structures in depth to be able to converge towards carbon neutrality.
Conclusion
The world has left the framework of the Great Moderation, which was defined by the great stability of both growth and inflation. Interests are no longer convergent if we stick to classical macroeconomics. However, the problem of climate change requires common action.
We must, therefore, imagine a form of instability in growth resulting from the adaptation to all of these changing elements. The constraints will not apply linearly in time and space. The volatility of growth will be stronger, but the upward trend in gross domestic product (GDP) will certainly be weaker.
We cannot yet assume that artificial intelligence (AI) will be the disruptive factor capable of generating strong and sustainable productivity gains on a macroeconomic scale. Those old enough will recall how similar anticipations developed during the emergence of the personal computer, the mobile phone and the Internet. These disruptions generated strong productivity gains on a microeconomic scale—that of the individual—without such a movement taking place on a global scale. This is also why we must invest to continue to innovate.
Inflation will also be more volatile and certainly a little higher. The verticality of the new economy limits arbitrage and opportunities for lower costs than during globalization. The transformation of the economy will also have to be done in an agile manner, and all adjustment variables will be called upon, including inflation, when necessary.
The objective in Europe will be to adapt to this new environment. We will have to invest, innovate and adjust our production system. Public debt can no longer be a means of running away to fuel demand—as has been seen in some European countries, including France—but as an ultimate instrument to fuel growth and the well-being of tomorrow.