By law, Germany, as Europe’s largest economy, aims at stability in foreign trade. Martin T. Braml and Gabriel J. Felbermayr investigate in a theoretical subsumption consequences of this mantra on climate policies while paying special attention to the relationship between international trade and CO2 emissions. They emphasize the importance of true costs in international trade.

The Federal Republic of Germany strives for an external balance. At least the “Stabilitäts- und Wachstumsgesetz” (StabG – Stability and Growth Law) from 1967 says so. It is unclear, however, what exactly characterizes such a balance: Does it follow, for instance, that the balance of trade and/or the current account should be zero? If so, Germany would be in a state of unbalance – and would have been for decades!

The German language does not distinguish between the concepts of imbalance, i.e., the presence of surplus or deficit in balance of payments statistics, for example, and disequilibrium, which describes a situation not in a so-called steady state in the context of general equilibrium theory. The former is the rule for many countries, the latter a sign of crises in which, for instance, financial markets collapse or, as is currently the case, supply chain disruptions.

A smaller export surplus is nothing to worry about

A sustained export surplus over many years, as seen in Germany, can be an expression of functioning welfare maximization: While the labor force potential was large in recent years, Germans continuously produced more than they consumed.

As a result, export surpluses emerged. There are some indications that a shift toward permanently lower export surpluses (or deficits) is taking place. This is not a cause for great concern because primarily welfare-relevant are the imports: they serve to satisfy consumption needs at home.

Of course, an economy cannot permanently consume more than it produces. This requires a reduction of foreign assets (dissaving) or debt financing. As long as deficits in the current account balance – which should be looked at differently from the trade balance since it also includes the primary income (essentially cross-border capital income payments) – are not driven by excessive government debt, there are hardly any reasons why the state should intervene to steer the current account balance in a certain direction politically. Free trade, i.e., the liberalization of goods and services, but also capital markets, is the welfare-optimal policy.

Externalities can cause market failures

The situation is quite different in the case of so-called externalities: When society incurs costs from international trade that are not priced in by the actors involved, market failure occurs. In this case, cross-border trade would be inefficiently high.

For example, this applies to greenhouse gas emissions, which are not priced equally in all countries. Countries with ambitious climate policies can experience carbon leakage: domestic production is replaced by imports, and there is only a shift of emissions abroad – helping the national CO2 balance, which is determined according to the territorial principle. In the worst case, total emissions even increase if production abroad is carried out using inferior technologies and, in addition, transport emissions are incurred.

But at its core, free trade is resource-conserving because those suppliers prevail on the market who operate with the highest efficiency, i.e., the lowest resource input per unit of output. And besides the larger choice in goods, shifting production due to differences in (relative) productivity is the essence of welfare gains through trade.

To fundamentally impede them would make neither economic nor environmental sense. At the same time, free trade alone is not a sufficient condition for producing global production efficiency as long as global externalities such as greenhouse gas emissions are not priced in or are priced very differently.

The relationship between CO2 emissions and trade policies

A uniform CO2 price, just like a CO2 border adjustment mechanism, first requires standardized recording of emissions along value chains. At the same time, emissions contained in intermediate inputs that are already priced must be exempted from further taxation in order to avoid double taxation, which ultimately penalizes production in small-scale value chains.

In addition, explicit CO2 prices like corresponding taxes or cap-and-trade schemes such as the EU ETS must be taken into account, as must implicit CO2 prices resulting from regulatory interventions, e.g., technical specifications.

Creating these conditions should be a priority goal of the German government’s initiative for a climate club initiative since a globally uniform price for emissions still seems unrealistic at present. Besides, scientific research clearly shows that technological progress has been the biggest driver of emissions reductions in recent decades. Political action should therefore promote it.

It is equally clear that the gains from trading significantly exceed the environmental damage, even at high assumed CO2 prices. Carbon leakage, on the other hand, is (currently) of less practical relevance. Therefore, the EU Commission should, if necessary, postpone its proposal for a Carbon Border Adjustment Mechanism (CBAM) if the envisaged model is not compatible with a non-discriminatory policy intervention under WTO trade law.

A breakup of the world trading system would do a disservice to climate efforts because technological progress would be extremely slowed down, and global production efficiency would decline.

Security policy is now in the focus

Another externality arises in the procurement of critical goods from geopolitical rivals that are able and potentially willing to use export deprivation as a means of foreign policy contestation. Cluster risks are particularly problematic in this regard. Until 2022, it seemed rational for every gas buyer in Germany to purchase large quantities of natural gas from Russia because of its good quality and favorable price.

In a market economy, this happens in an uncoordinated and decentralized manner. In aggregate, however, this means that Germany’s sovereignty in foreign and security policy is considerably restricted because the corresponding quantities of gas can hardly be substituted in the short-term or their renunciation causes considerable economic costs.

As a rule, geopolitical considerations play hardly any role in the decision-making process of a gas buyer. They represent non-internalized procurement externalities that, in principle, justify political intervention. Diversification of supply sources can be administered through import quotas. Quotas should be allocated according to considerations of security of supply in the event of a crisis.

The meaningfulness of true costs for international trade

These considerations are not limited to energy issues: A relatively high degree of self-sufficiency is ensured in the food sector through enormous government subsidies. However, self-sufficiency is associated with high costs and is thus diametrically opposed to welfare maximization.

At the same time, total dependence on one’s own country can also mean a considerable cluster risk. It is better to price product-specific externalities, find quota arrangements, including the skimming of quota rents, and build up stocks similar to strategic oil reserves. Smart stocks, such as for pharmaceuticals, would last as long as it takes domestic production time to substitute for the corresponding imports.

Trade policy faces the task of addressing externalities arising from cross-border trade. When these costs are fully priced, the degree of optimal openness presumably declines. However, this is not an abandonment of welfare; in fact, it is welfare-enhancing precisely because climate and security considerations are welfare-relevant, too. A foreign trade equilibrium should be characterized by the fact that true costs are prevalent in international trade.

This blog post as a summary of the study “Außenwirtschaftliches Gleichgewicht als wirtschaftspolitisches Ziel im 21. Jahrhundert” (in German) is a translation. 

About the authors

Martin Braml is founder and partner of Munich Economics and lecturer at the University of Passau.

Gabriel Felbermayr is director of the Austrian Institute of Economic Research and professor at the Vienna University of Economics and Business.

Read more on the green transition:

3 Things to Watch for in the EU’s Plan for Energy Independence

How to Fund Climate Investments in Times of Budget Consolidations

A Green Europe: Regional Strengths and Weaknesses and the Green Transition