The Economic Impact of European De-industrialization: Geopolitics Takes Center Stage

3 February 2023 17:45

Using a satellite model, we analyze the economic impact of European deindustrialization and find substantial adverse effects on the exchange rate, GDP, and unemployment.

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Balance of Power intro

Geopolitics is back with a vengeance. The US and Asia have been actively thinking about strategic autonomy on a political level for some time now - ensuring the future energy supply and securing essential raw materials and semi-finished goods crucial for technological and military sovereignty. Just recently, the US government has increased political pressure on the Netherlands and Japan to close a deal to limit the export of semiconductors and lithography machines to China. China, in turn, has hinted at export restrictions on solar energy technology.

In Europe, the realization is slowly dawning that the functioning of the economy is increasingly determined by geopolitical decisions, which often stand in stark contrast to the ideal of apolitical free trade (see Ricardo, 1817). There is a risk that Europe will not be able to secure strategic autonomy on all fronts in the harsh reality of geopolitics, as we recently saw in the energy sector. This development may be accompanied by a loss of European competitiveness, a sharp deterioration of the balance of payments and public finances, and ultimately even lead to partial deindustrialization, as part of the European industrial sector disappears or moves, for example, to the US. This increases the risk of a balance of payments crisis, something we regularly see in emerging markets but rarely in developed economies.

In this report, we analyze the economic impact of such a European deindustrialization scenario. Traditional macroeconomic (DSGE) models are insufficient in calculating the effects of such a scenario, especially because they struggle to deal with long-lasting imbalances. Therefore, we have developed an alternative satellite model that is better suited for this. This satellite model takes into account the risk of structurally higher input costs, reduced export opportunities, lower wage developments, and a balance of payments crisis with less room for fiscal and monetary easing.

The economic impact in a scenario where we assume a 10% decrease in industrial production in the eurozone is greater than according to traditional models, which, for example, assume that countries can "export themselves out of a crisis" through a lower exchange rate. We take into account that there is less room for this within the current geopolitical power play. Although we do stress that it is not our ‘base scenario’, in this exercise, the value of the British pound and the euro drop significantly, and the economies of the EU and the UK are over 7% smaller after a period of four to five years than without such a structural shock to industry. Unemployment also rises dramatically in such a scenario, reaching levels seen during the global financial crisis and the eurozone crisis.

Download the full report here