A theory of economic coercion and fragmentation

Summary

Focus

Concern is growing over global trade fragmentation driven by competition among dominant powers. In a highly integrated world, nations increasingly rely on financial systems, trade networks and resources controlled by these powers. This creates leverage for these powers to impose political and economic demands. While the potential implications for global trade and production are of great policy interest, a formal framework to understand these issues has been lacking.

Contribution

This paper presents a new theoretical framework emphasizing a trade off between gains from integration and economic security. The framework shows how the very mechanisms that foster global trade, such as economies of scale and specialisation, can be weaponised by dominant powers. It shows how nations' efforts to balance domestic economic security with the benefits of global integration can result in over fragmentation of global financial and trade systems.

Findings

A "fragmentation doom loop" can emerge when multiple countries attempt to reduce their dependence on a dominant power, leading to inefficient global fragmentation and welfare losses. Financial services, with their global reach and limited alternatives, are a key tool of economic coercion. Empirical evidence highlights that the United States exerts its dominance primarily through financial services, while China relies more heavily on its manufacturing trade as the source of its influence.

Abstract

Hegemonic powers, like the United States and China, exert influence on other countries by threatening the suspension or alteration of financial and trade relationships. We show that the mechanisms that generate gains from integration, such as external economies of scale and specialization, also increase these countries' power to exert economic influence because in equilibrium they make other relationships poor substitutes for those with a global hegemon. Smaller countries can insulate themselves from geoeconomic pressure from hegemons by pursuing anti-coercion policy: shaping their economies in ways that insulate them from undue foreign pressure. This policy faces a tradeoff between gains from trade and economic security. We show that while an individual country can make itself better off, uncoordinated attempts by multiple countries to limit their dependency on the hegemon lead to unwinding of the global gains from integration and inefficient fragmentation of the global financial and trade system. We study a leading application focusing on financial services as both tools of coercion by the hegemon and an industry with strong strategic complementarities at the global level. We provide estimates of geoeconomic power for the US and China and show empirically that the geoeconomic power of the United States relies strongly on financial services while that of China loads more on manufacturing trade.

JEL classification: F02, F5, F12, F15, F33, F36, F38, P43, P45

Keywords: geoeconomics, geopolitics, economic security, economic statecraft, payment systems

• Discussion by Javier Bianchi