In its fight against its economic vulnerability to China, the European Union is committed to diversification. But it is not the panacea. In fact, dependency acts as a rather crude measure to assess vulnerability.
In the most recent document of the European Commission on the strategic dependencies of the EU, the term “diversification” appears more than 28 times. It represents a key pillar of proposed policy responses to reliance on Chinese supplies. The entire world depends on China for rare earth metals, metals, and magnets produced from them: China accounts for 63% of the world’s rare earth oxides, 85% of refined minerals, and 93% of world production of rare earths. magnets. As for Europe, the recently discovered rare earth deposit in Sweden, the continent’s largest known mineral reserve, may help improve Europe’s resilience to rare earth supplies.
However the crux The issue is not dependency, but vulnerability. That is, the problems derived from interruptions in commercial exchanges measured in terms of economic costs, social unrest and, possibly, political instability.
Vulnerability can exist even without dependency
Dependency acts as a rather crude measure to assess vulnerability. The European Union is almost entirely dependent on Madagascar for its supply of vanilla beans, but even a complete loss of that supply would hardly cause serious macroeconomic problems. Moreover, vulnerability can exist even without dependency: Spain has never been dependent on Russian natural gas supplies, but the lack of supply to other European markets sharply increased the price of electricity across Europe, severely affecting Spain and thus revealed his vulnerability.
Vulnerability exists when three aspects are combined. First, a significant disruption of economic exchanges must be plausible. Secondly, the affected economic sectors must see their ability to adapt to shocks limited by reorienting towards alternative sources and/or enduring a reduction in demand. Third, the consequences of the shock must have a significant impact on the overall performance of the affected economy. The European Commission has done some necessary analysis of European vulnerabilities, but much remains to be done at the national level.
As a response to vulnerability, diversification has drawbacks
As a response to vulnerability, diversification has drawbacks. For companies, diversification is a natural risk management strategy. It will still occur in response to market forces if the additional costs are small. Most companies are diversifying away from the Chinese market, not because of a government diversification strategy on the part of their home country, but rather in response to the market impact of Chinese policies. However, as a geopolitical strategy, diversification is usually expensive, and the costs have to be assumed, either by economic agents (companies, consumers) or by taxpayers, so it must be adopted with caution. In a single crisis, security considerations may succeed in mobilizing support for the additional spending incurred. However, over time, concerns about security of supply tend to fade into the background and diversification becomes a very expensive alternative.
The experience of the oil crises of the 1970s can serve as an example. The dominance of Middle Eastern exporters over world oil markets has been maintained to this day as they hold huge reserves with very low production costs and therefore the possibility of offering cheap oil outweighs the political risks.
If the cost of diversification is financed through subsidies or imposed on consumers through trade protectionism, there is a risk of creating a situation based on high-cost production and vested – and very powerful – interests lobbying for continue that protection. The EU’s common agricultural policy originated in concern for food security and ended up becoming a highly distorted policy of sectoral protection with a powerful lobby.
Geopolitical diversification efforts can fuel a grant race
Geopolitical diversification efforts can also foster a grant race between countries following the same strategy. At worst, diversification produces all of these problems simultaneously, as with energy: Europe has remained dependent on imports of fossil fuels and dependent on high-cost domestic coal and lignite producers (and their investment groups). pressure).
Finally, diversification defines solutions to geopolitical vulnerabilities in terms of alternative supplies and tends to displace alternative approaches focused on conservation, substitution, and recycling. Conservation allows importers to get by with less, thus reducing dependency; the same happens with recycling, by offering national alternatives to imports. Substitution removes the need for certain inputs by developing alternatives, with the possibility of abolishing dependency altogether.
“Diversification defines solutions to geopolitical vulnerabilities in terms of alternative supplies and tends to displace alternative approaches focused on conservation, substitution and recycling”
Taken together, better demand management can help both manage geopolitical vulnerabilities and alternative supplies, with the added benefit of being more sustainable.
Diversification strategies risk supporting expensive and ineffective policies
In summary, diversification strategies present important complications. They are intuitively attractive and therefore easily gain political support, but they risk ending up supporting expensive and ineffective policies. Given the time frames required to develop alternative sources, they also represent a long-term structural response to geopolitical vulnerabilities that typically flare up suddenly.
Although it is difficult to accurately predict the responses of economic agents to shocks, there are measures that both companies and governments can take to increase their flexibility and, therefore, their resilience. One of these is the accumulation of reserves, including strategic reserves owned or mandated by governments. Another is to encourage innovation. Flexibility can also be built into manufacturing systems at all levels, thereby improving resiliency, and typically at relatively low cost.
The approach of the European Commission tends to equate strategic dependency with vulnerability
In its efforts to assess the problems and develop policy responses to Europe’s vulnerability to supply shortages, the EU has been well ahead of many of its member states, including Germany, its largest economy. As part of its new industrial strategy update, the EU undertook an assessment of its strategic dependencies in 2021, followed by an in-depth review in 2022. The Commission’s approach tends to equate strategic dependency with vulnerability and to consider diversification as the key answer. It includes the national security sector, where the issues are fundamentally different. The notion of “strategic” dependency obscures that difference and is open to abuse.
Thus, while the European space industry may be important from the point of view of national security, as well as for reasons of prestige and industrial innovation, it hardly deserves to be treated as a priority in terms of economic security. Likewise, the EU’s policy responses emphasize industrial policies and international cooperation with partners with similar concerns. Both are important, but demand-side policies receive much less attention. This is why you run the risk of costly misallocation of funds, investing in uncompetitive industries and forgetting the industries where the EU is strongest.
In the end, there is a limit to what the EU can do to identify and address the risks of Europe’s vulnerability to economic shocks; the bulk of the work must be done by the Member States. The accumulation of reserves deserves much more attention than it has received so far, because it buys time to make adjustments both at the European level and in the Member States.
An important precedent for coordinated storage policies is the International Energy Agency’s emergency oil delivery system. This agreement sets targets for national oil reserves, stipulates mandatory conservation efforts in the event of severe disruption, and provides for a redistribution of available supplies to the benefit of the most affected countries. It could serve as a model for European efforts to reduce vulnerabilities in its trade dealings with China.
Article originally published in English on the website of The Diploma and of MERICS
