The problem with 'geoeconomics'

"Geoeconomics" is the term being used to describe this phenomenon. This increasingly popular concept is based on the idea that economics has failed to recognise how foreign governments can use economic links to achieve geopolitical goals. To attack these Trojan horses, geoeconomics recommends redirecting trade towards geopolitical allies, bringing sensitive production onshore, stockpiling imports and even nationalising some businesses.

Geoeconomics certainly has the attention of many policymakers. But there's a problem: while the "geo" makes sense, the "economics" doesn't stack up. Geoeconomics rests on a misunderstanding of how markets and international trade rules function. More importantly, it misunderstands the role markets and rules play in defeating economic coercion and buffering economies from their impacts.

To see why, consider some recent examples. China has hit a whole range of Australian industries - from barley and beef to wheat and wine - with trade restrictions. Many commentators warned of devastating consequences: goods perishing on shelves, whole industries collapsing as billions of dollars of revenue gets ripped out from underneath them. The reality, however, turned out to be very different.

While the value of these exports to China fell $11.7 billion a year, the value of those same exports to the rest of the world increased by $13.4 billion. Covid complicated things, but what happened is exactly what we would expect from well-functioning markets: prices fell, exchange rates adjusted, businesses pivoted and new customers emerged. While some suppliers have had to put up with lower prices, the headline warning that billions of dollars of economic activity was about to vanish into thin air was based on a misunderstanding of how markets work. They found alternatives, buffered the Australian economy and defeated attempts at coercion without the government having to lift a finger.

We saw the same thing when it was supply rather than demand that vanished. When China restricted the export of rare earth metals to Japan in 2010, the fear was that whole industries in the electronics sector would be hobbled. The embargo caused disruptions, but the Chinese government quickly backed down after an adverse ruling against it in the World Trade Organization. Unfortunately for China, markets had already dealt their punishment: they had sought out alternative suppliers and, where none was available, started enticing new ones into the market by increasing demand and pushing up prices to encourage investment. Not only did China fail to achieve any political objective in pressuring Japan, it triggered a process that will cut it out of a highly lucrative market in which it could have maintained a global monopoly for years to come.

We saw a similar thing happen when China imposed tourism embargoes on South Korea after the government in Seoul installed THAAD anti-ballistic missile systems. Businesses diversified away from China and found new customers in new markets. Shifts in prices and exchange rates saw a boost in demand both within Korea and from other countries in the Asia-Pacific. China's actions sparked a global wariness towards Chinese tourists - costing it dearly in markets around the world through reduced confidence and increased suspicion.

The same thing happens when the West is the aggressor. Donald Trump imposed tariffs on hundreds of billions of dollars of Chinese exports in a misguided attempt to punish the Chinese government, hurt its economy and create more jobs in America. Analysis from the International Monetary Fund found exactly what hundreds of years of economic theory would predict: that almost 100 per cent of the cost of the tariffs was paid for by American importers, not Chinese exporters. Tariffs are nothing more than a tax on your own citizens.

Trump's tariffs on steel - claimed to be necessary on national security grounds - similarly backfired. They may have supported the US steel industry, which employs only 140,000 Americans and contributes only $US40 billion to the economy, but they did so at the cost of the industries that use that steel as an input, which collectively employ 6.5 million Americans and contribute more than $US1 trillion to the economy.

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Similarly, when the United States imposed sanctions to prevent Europe from engaging with Iran, both parties found ways to work around them by creating new financial institutions. They have a long way to go, but the more America uses the dollar as a weapon, the more markets will seek to diversify and find alternatives, whether they are existing currencies, digital currencies or new reserves created through international co-operation.

All these examples highlight two critical things missed by the rhetoric of geoeconomics: the power of markets in buffering economies from any attempts at economic coercion, and the power of international rules in stopping those attempts in the first place. This puts the concept of geoeconomics in an awkward spot, revealing that heavy-handed measures like government-directed trade, local production and nationalised businesses make little sense in the context of well-functioning markets.

For those concerned about international economic coercion, the better solution is to build more flexibility into Australia's markets so they can do an even better job at buffering the Australian economy and defeating coercive attempts from other countries.

For product markets, this means reducing barriers to entry and barriers to expansion, so businesses can enter, expand and exit an industry as easily as possible. For financial markets, this means ensuring a flexible exchange rate, responsive monetary policy, and reformed credit and insolvency laws that make it easy for new businesses to replace old ones. For labour markets, this means having a strong social safety net with proper retraining and reskilling programs to help people move between industries and locations to find work. And for fiscal policy, it means having demand-driven programs in place that automatically direct financial support to the people and regions that need it.

Geoeconomics might sound tempting for troubling times, but when security masquerades as economics, we end up adopting policies that make us poorer and less secure. Australia's security is underpinned by our prosperity, both of which have been built on developing flexible markets, strong institutions and predictable international rules. They've seen us through tougher times than this. Abandoning them now would be a fool's errand.