European Economic Security in an Age of Interdependence

The world has changed. The age of unfettered globalisation, systemic convergence and increasing cultural understanding is over and is probably not coming back in the foreseeable future. Instead, multiple fault lines are opening up (Campos et al. 2023, Aiyar and Ilyina 2023).

The role the EU played in the last few decades – building bridges, promoting increasing interdependence, supporting multilateral rules and institutions – seems to be out of date in a world of large-scale shocks, polarisation and power play. First, the outbreak of the COVID-19 pandemic and the subsequent supply chain congestion highlighted the vulnerabilities of Europe’s supply chains. Then, the Russian aggression against Ukraine served as a wake-up call over Europe’s dependency Europe on energy. Finally, economic coercion by China against Australia and Lithuania and the increasingly adversarial tone of the US-China relationship have underscored the need for a comprehensive reassessment of the EU’s economic security strategy. For a while, Europe nurtured the hope that it could avoid being engulfed in the US-China confrontation and could maintain good relations with the countries of the Global South. It gradually discovered the extent of the mistrust it elicited in many developing countries.

How should Europe respond? The second Paris Report (Pisani-Ferry et al. 2023) focuses on one of the major policy issues currently facing Europe: economic security challenges in the face of supply chain vulnerabilities and geopolitical shocks.

This report forms the first output from a new joint initiative between CEPR and Bruegel: Important Topics of Common European Interest (ITCEI). It comprises five papers that examine where Europe is vulnerable and where and how it should de-risk, taking into account history, trade dependencies and policy instruments. Morgan Kelly and Kevin O’Rourke examine the history of industrial policy in the shadow of conflict. Isabelle Mejean and Pierre Rousseaux identify trade dependencies that may expose the EU to trade disruptions using a novel methodology that considers the possibility of substitution away from disrupted input sources. David Baqaee, Julian Hinz, Benjamin Moll, Moritz Schularick, Feodora Teti, Joschka Wanner and Sihwan Yang quantify the short- and long-run effects on the economies involved of a hard decoupling between China and Russia on the one hand and the EU the G7 on the other, focusing on Germany. Chad Bown analyses the economic security of the EU from a trade policy perspective, while Conor McCaffrey and Niclas Poitiers discuss instruments of economic security.

How Europe Should Respond to the New Challenges

Europe retains an underexploited asset: the size of its market. This is why the right response must be more EU integration. Its still considerable economic weight should help buttress common defence against aggression and acts of economic coercion.

In addition, economic security objectives could justify policies that reduce the vulnerability to external disruptions through trade of financial channels. While firms have incentives to reduce risks to economic security with respect to trade by diversifying their suppliers and broadening their customer bases, they may overlook aggregate vulnerabilities across the supply chain. Moreover, they might fail to consider the broader societal costs of dependency and coercion, which can outweigh the private costs to individual firms.

At the same time, policy intervention must be mindful of costs to the gains from trade, multilateral cooperation and cohesion within the EU. Economic security should not become the entry point for wholesale protectionism, and it should not serve as an instrument to protect inefficient producers with powerful backing. Vulnerabilities also exist in closed economies, and openness is often the best insurance against them. The challenge lies in balancing the benefits of international trade with the need for de-risking.

Our analysis leads to four main conclusions.

First, the identification of critical import dependencies is important but also extremely difficult. Progress has been made, with Mejean and Rousseaux going further than all previous attempts. But while there is consensus on a small list of products that should be de-risked – semiconductors, critical raw materials and some pharmaceuticals – this list is clearly incomplete (for example, by missing upstream products that enter many value chains). At the same time, it is hard to go much further without worrying about going too far. Improving analysis of vulnerabilities would require (1) more work on determining which imports are critical in the sense that an import disruption would have large costs; and (2) better data on indirect rather than just direct trade dependencies.

Second, while the European Commission has done commendable work in beginning to address import dependencies and establishing the legal basis for responding effectively to economic coercion, its economic security strategy has some notable blind spots. While import vulnerabilities have received much attention, vulnerabilities via concentrated exports, which can make firms and entire sectors vulnerable to coercion, have received much less attention. Addressing these vulnerabilities may require instruments that incentivise firms to diversify exports, such as compulsory insurance against concentrated risks or export taxes. This will need to be complemented by a strategy to address exposures through local production rather than trade, making firms vulnerable to expropriation risk. Another major blind spot is the lack of instruments to address coercion through financial channels, such as interfering with payments. While European firms are not currently on the receiving end of such coercion, this may change if Donald Trump returns to the White House.

Third, EU economic security requires a major reinvigoration of the Single Market agenda, as part of a general resilience strategy that complements the attempt to de-risk individual import and export dependencies. Unlike the latter, this does not involve trade-offs between security and growth, and it is not sensitive to assumptions about where the next shock will come from and which dependencies are particularly critical. It would help the EU resist external shocks and coercion – whatever the source and the channel – by allowing faster re-direction of trade and supply and by improving automatic risk-sharing. Better risk sharing, in turn, would make the EU more cohesive and would make it harder to exploit internal divisions. The speed of the EU response and its ability to deter coercion could also be improved by activating the retaliatory powers given to the Commission by the EU’s Anti-Coercion Instrument, without requiring confirmation from a majority of member states.

Fourth, there is an open question about whether in a world of heightened geopolitical risks, the EU is too trade-integrated with both China and the US, exposing itself to major economic disruption in case it is drawn into a trade conflict between or with these countries. With respect to the US, the probability of an all-out embargo seems sufficiently low to answer the question in the negative. Instead, the EU may need to prepare (mainly politically) to fight a trade war with the US if President Trump returns and reinstates tariffs on the EU. With respect to China, the answer is less obvious. Baqaee et al. show that the cost of reducing trade integration slowly is much lower than that of sudden decoupling. Whether the EU should purse broader de-risking thus depends on the likelihood of a sudden, embargo-like collapse in trade, compared to the benefits of maintaining integration. Whatever action the EU takes should remain within WTO rules, and it should preserve the ability to collaborate with China in areas such as climate change and WTO reform.

The new global geoeconomic map may necessitate an EU pivot towards economic security, even beyond the pivot that has already happened. But economic security must not become an excuse for protectionism, and it must preserve international cooperation. This requires innovative policy instruments, joint preparedness, contingency planning and stronger governance mechanisms at both the EU and the international level.