Five Reasons Why the EU Needs a Strategic Trade Policy

In the early 1980s, the theory of strategic trade policy was developed. The question was: How can a country increase its own prosperity through trade policy measures in the case of market imperfections – especially in oligopolistic markets? Today there are other market imperfections that also justify the use of trade and economic policy instruments.

Principles of strategic trade policy

Government intervention in international trade can cause welfare losses – for the country implementing the intervention and also for the countries against which the measures are directed. This is what the standard model of trade theory tells us. However, in the case of market imperfections, the use of trade policy instruments can increase the welfare of one’s own country.

In strategic trade policy theory, market power is seen as a reason for government intervention. Perfect competition is replaced by oligopolistic competition. This means that there are only a small number of suppliers on the world market – who can demand a higher market price and thus achieve higher profits – so-called oligopoly rents.

In the theory of strategic trade policy, the reasons for this market power are primarily static economies of scale (e.g. high fixed costs in research and development) and dynamic economies of scale (learning effects of employees).

Instruments of strategic trade policy

Common instruments of strategic trade policy are subsidies. Two main types can be thought of:

The first is subsidies that reduce companies’ cost of production. To avoid permanent public support, these subsidies should be limited to investments in physical and human capital and in research and development. When domestic companies become more competitive, government can stop its payments.
Second, export subsidies are possible, which companies receive only for exported products. These subsidies do not improve the productivity of the companies and may therefore have to be paid permanently.

In addition to subsidies, public investment is also part of strategic trade policy. If a government invests in physical capital, human capital or know-how or technology, this benefits private companies.

Finally, with tariffs and non-tariff barriers (classic trade policy instruments) can also be used to strengthen the competitiveness of domestic companies in oligopolistic world markets.

Five reasons for an EU strategic trade policy

Today, there are additional reasons for a strategic trade policy beyond the specifics that lead to an oligopolistic market structure. Five of them will be briefly discussed.

A first reason involves cluster risks in imported raw materials, intermediate inputs and final products. From an individual economic point of view, for example, it was absolutely rational from the perspective of many companies in EU countries to rely on Russian gas; after all, it was the cheapest available before the Russian attack on Ukraine. However, if all companies in an EU country choose Russia as their supply market, the result is a cluster risk that makes the entire economy dependent on Russian gas. If these natural gas imports no longer take place, there will be production slumps that will affect the entire EU economy. There is thus a negative procurement externality in foreign trade.
A second rationale for government intervention in foreign trade arises when not all economies respond to a negative external effect to the same extent. One example is carbon dioxide (CO2) emissions. In many cases, EU policy responds to this market failure by imposing a carbon price on greenhouse gas emissions. Additional government intervention becomes necessary when there are no or very low carbon prices to pay in the rest of the world, as emissions-intensive economic activities can then be expected to shift to countries with less stringent climate policies – resulting in carbon leakage.
Third, the advance of digitalisation is leading to an increase in natural monopolies. The reason for this is the special cost structure of many digital goods and platforms: While the development of these goods or the establishment of these platforms is associated with high fixed costs, the marginal costs of production tend toward zero.
A fourth motive for trade policy intervention exists when there is no free market access. This is the case, for example, when foreign companies do not have access to domestic public procurement contracts or when capital controls prohibit foreign investors from participating in domestic companies.
Fifth, a government may decide to take trade policy measures if there are market distortions abroad, e.g., subsidies or import tariffs. Such distortions are not new, but they are likely to increase in the future. The reason: It is to be feared that in the future, international trade relations will no longer be viewed solely in terms of economic advantage, but geopolitical considerations will play an increasingly important role. As a result, many economies will use trade policy instruments to achieve their political goals. In addition to tariffs and non-tariff barriers, possible instruments include sanctions, export restrictions, export bans and much more.

Economic policy challenges for the EU

The theoretical rationale that strategic trade policy can increase the welfare of an economy in the case of market distortions is based on a number of assumptions. However, if these are not met in reality, there is no longer any guarantee that government intervention will be welfare enhancing. Five challenges play a central role in this context.

If the EU aims to support industries or technologies, a strategic trade policy can only produce the desired results if the promoted sectors actually create promising products and technologies in the future. However, it is by no means guaranteed that the government has the knowledge required to make this call – and thus, there is no guarantee that it will promote the right sectors and technologies.
The promotion of selected sectors involves the increased use of factors of production, but these are then no longer available for alternative uses. This is associated with opportunity costs that need to be considered.
The costs of a strategic trade policy also include the negative consequences of using trade policy instruments for one’s own country. If government subsidies are financed by a tax increase, this implies price increases elsewhere in the economy that weaken the price competitiveness of domestic companies. The same applies to import restrictions because they raise the prices of imported raw materials and intermediate inputs. In both cases, the purchasing power of private households decreases, which can lead to a reduction in the demand for consumer goods. Finally, it must be considered that protected sectors of the economy can tend to be inefficient because of the lower competitive pressure. This may slow down technological progress.
If a country promotes a certain sector in its own country and thus increases the profits of the companies involved, this does not automatically increase national welfare. The prerequisite: these profits must remain within the country. However, if the owners of the companies concerned are based abroad, the profits flow there instead.
The positive effects of strategic trade policy on national welfare are based on foreign countries not taking countermeasures. However, foreign governments can react with retaliatory measures. This worsens the export opportunities of EU companies.

Recommendations for economic policy action

From the preceding, it can be concluded: In the coming years, there will likely be an increasing number of cases in which trade policy intervention by the state can increase overall EU welfare. However, at least two challenges need to be considered for government intervention to be welfare-enhancing.

Challenge No. 1: It is necessary to identify the economic sectors for which a strategic trade policy should be applied. For example, in order to reduce domestic import dependency, the government must be able to identify the raw materials, intermediate inputs and final products for which there is critical import dependency for the entire economy.

There are established methods with which, for example, the EU Commission diagnoses import dependency. Criteria by which the critical import dependency of a particular product can be identified are the extent of concentration on supplier countries of this product, the share of imports from non-EU countries in total imports of this product and the ratio of imports from non-EU countries to the corresponding exports of the EU.

However, these indicators do not indicate whether there are substitutes for the products identified in this way – from other countries or in the form of alternative products. It is also unclear how high the future domestic demand will be – if an imported product identified as critical is hardly needed in the future, no measures may be required to reduce import dependency. In addition, the importance of these products for further domestic production processes is not considered.

Challenge No. 2: The task is to identify the appropriate trade policy instruments – including their precise design. For example, the specific design of a carbon border adjustment mechanism requires clarification of numerous detailed questions: How will the CO2 content of an imported product be determined? How are emission prices applicable abroad taken into account? How can a violation of international rules on cross-border trade be avoided?

These and other questions must be answered based on robust empirical evidence, factoring in indirect effects and economic interactions. If this is not done, there is a risk that the instruments of modern trade policy will cause more economic damage than benefit.

Note: This post is a revised version of “Strategische Handelspolitik 2.0”, which first appeared in German on Makronom. Both blog posts are based on the article “Strategische Handelspolitik 2.0“, published in the journal Wirtschaftsdienst.

About the author

Thieß Petersen is Senior Advisor at the Bertelsmann Stiftung, specializing in macro-economic studies and economics. His focus lies on the causes and effects of financial and economic crises as well as the chances and risks of globalization. Among others, he has recently worked on the effects of carbon pricing and the benefits of a potential global climate club.

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