Globalization 2.0

Jacob Kirkegaard

Peterson Institute for International Economics and German Marshall Fund

Jacob Kirkegaard is a Senior Fellow at the Peterson Institute for International Economics and German Marshall Fund.

Path to German-American Prosperity in the Age of Decarbonization and China’s Economic Slowdown?

Two megatrends will dominate the global economy in the coming decade—our accelerating efforts to decarbonize and the inevitable brutal slowdown of Chinese economic growth. The combination will pose dramatic, if different, challenges to the United States, Germany, and the transatlantic relationship.

Russia’s assault on Ukraine is pushing all of Europe and especially Germany to hasten the exit from first Russian and then all fossil fuels. Crucial national security concerns are a potent ally of already heightened public climate change concerns across Europe. While in the short-term, Germany and Europe will burn more fossil fuels and have seen gas and therefore electricity prices rise dramatically, this relative price shock combined with the urgency to confront Russia will in the medium-term help Germany and Europe meet its 2030 and 2050 climate goals. The decision to exit nuclear power is an inexplicable carbon own goal by Germany but will not alter the now much faster rollout of renewable energy. The pre-war planned offshore wind and solar capacity will not only be added to the European power grid in the coming years but multiplied, making the current spike in energy prices likely the last to ever hit the region. In the future, the marginal price of electricity in Europe will be dictated by the level of power sector technology innovation and the cost of investment. In short, parameters that will decline predictably over time.

Meanwhile, the European carbon emission price remains high at around 65 euros per metric ton, providing an ongoing incentive to further reduce emissions. This incentive will gradually increase for EU businesses, as allocations of free emissions are phased out and companies must instead purchase them at market prices. This again makes the political pressure for the EU to “level the carbon playing field” through an imposition of Carbon Border Adjustment Mechanism (CBAM) tariffs on select carbon-intensive imports irresistible, including potentially on U.S. exports. Ukraine’s fast-tracking of Europe’s climate ambitions hence also poses challenges for the transatlantic trade relationship.

The ability to align the U.S. federal regulatory-driven approach to reducing emissions with the EU relying on explicit carbon pricing to achieve the same goal is crucial if a transatlantic “carbon club” is to be achieved and the imposition of carbon-based tariffs on transatlantic trade avoided.

Meanwhile, in the United States, the Biden administration has for the first time steered a major federal spending program to promote decarbonization through Congress as part of the recent Inflation Reduction Act (IRA). The political price for this passage in the Democratic Party was, however, protectionist earmarking of federal government climate cash to only U.S.-made goods and services. This will not only challenge continued transatlantic climate collaboration but also potentially damage American attempts to engage Asia-Pacific nations in closer trade and economic relations without China.

Also included in the IRA was a revised and now explicit Congressional permission for the federal Environmental Protection Agency (EPA) to regulate CO2 emissions as an air pollutant. The U.S. Supreme Court struck down this power in June 2022, casting doubts on the ability to use federal regulation to reduce U.S. carbon emissions. Armed once again with this powerful regulatory tool, there is renewed hope that the EPA and the entire federal government can—using regulatory means and the economic incentives included in the IRA—compel a reduction in U.S. carbon emissions of a comparable scale to that achieved in the EU relying on the ETS carbon price and cap and trade scheme. The ability to align the U.S. federal regulatory-driven approach to reducing emissions with the EU relying on explicit carbon pricing to achieve the same goal is crucial if a transatlantic “carbon club” is to be achieved and the imposition of carbon-based tariffs on transatlantic trade avoided.

Decarbonization and technology will likely drive transatlantic energy prices ever lower in the future, but it is the imminent growth slowdown in China that will ensure that today’s inflation spike remains transitory. China’s long-term potential growth rate is no more than perhaps 1-2 percent per year, or in other words no more than the level in the United States and Germany and at least Northern Europe. China’s economic convergence will in other words soon stop at an average GDP per capita level far below that of the OECD. This is the inescapable conclusion from looking at the components of long-term potential growth—the growth of the working-age population, growth of capital spending and productivity—in China.

China’s market will of course remain very large in the future, just not quite as indispensable for global firms as in recent decades.

Most worryingly for China, the country is entering an age of rapid demographic decline with a working-age population projected to shrink by 0.4-0.7 percent per year in the coming decades. Given the fact that the incoming workforce in the next 20 years has already been born, and that China’s large population means there is nothing hypothetical increased immigration to China can do to alter this outcome, this is simply a given. China meanwhile has had an unprecedentedly high level of investment in its economy at over 40 percent of GDP since the Global Financial Crisis in 2008-09. This is a level of investment achieved only briefly and typically shortly before a crisis hit in other fast-growing Asian economies, making it implausible that China can further sustainably increase its level of investment in the future. Indeed, investment in China is likely to decrease in the years ahead. Lastly, the IMF in its most recent Article IV report on the Chinese economy estimated the average total factor productivity in China from 2010-2019 to be just 0.7 percent per year. In short, if you add up these three components and give the Chinese authorities the benefit of doubt on future pro-growth policy reforms, you can plausibly arrive at a long-term potential growth rate of 1-2 percent, but not a higher number.

China’s weight in global growth is hence likely to fall significantly in the coming years, and German industry’s most important export market will lose much of its allure. It is in other words not just increased political risk, but basic profit considerations that ought to make German and other companies reconsider the relative importance of sales in the Chinese market in the future. China’s market will of course remain very large in the future, just not quite as indispensable for global firms as in recent decades.

A Chinese economy slowing to the growth rate of the U.S. one, meanwhile, should help nullify many of the concerns in the United States of China becoming the world’s dominant economy and military power. Rational policymaking would certainly question whether a U.S. defense budget of $800 billion is truly warranted if China does not grow faster than America.

Decarbonization led by the West and a dramatically slowing Chinese economy will together see the United States, Germany, and other G7 countries continue to dominate global policymaking in the 21^st century. Provided major transatlantic schisms can be avoided, the United States and Germany can hence continue to help lead Globalization 2.0 in the future.