Europe’s Response to the U.S.’ Inflation Reduction Act (Summary)

Bruegel

Bruegel, a Brussels-based think tank, was founded in 2004 on the 50th anniversary of the Élysée Treaty between France and Germany. It employs 50-60 individuals total and is in some ways similar to an international organization, because of the government members. Initially limited to EU governments, the charter was modified after the UK’s departure from the EU, allowing for other governments to hold membership. Despite its contributions, Bruegel has maintained its independence from the European Commission.

Net Zero Industry Act (NZIA)

This presentation has a particular emphasis on the EU’s NZIA, which focuses on the domestic dimension of the EU response to the Inflation Reduction Act (IRA). It is the most recent and weakest response by the EU to the IRA.

Philosophy of EU economic policymaking (at the EU level)

Europe’s market-based model, developed in Germany after World War II, gained consensus in the 1970s and the 1980s, and was codified in the Lisbon Treaty. The treaty defines the competencies of the European Commission, responsibilities of members states, and functioning of the EU. The treaty emphasizes that competition within the EU promotes efficiency and growth without a trade-off between competition and external competitiveness.

This is an important framework, especially in the historical context of some European countries, including Germany and Italy, which during the interwar period, believed that limiting competition within their countries benefitted their competitiveness in international markets. They prioritized the promotion of national champions into global markets, with somewhat disastrous results for the world. The European Treaty’s philosophy of competition and external competitiveness is a stark contrast to that perspective, and it is maintained in order to ensure that a single market is in fact possible throughout the EU by preventing national governments from bolstering their own corporations at the expense of other EU corporations and market-based competition.

The EU also supports the multilateral trading system and World Trade Organization (WTO) because of the belief that international trade and multilateral rules benefit the EU.

The EU has the perspective that growth and development among the EU and its trading partners such as Japan, the U.S., and emerging markets, such as China are positive developments for the EU as well.

The EU institutions, such as the European Commission, are strong regulators, meaning that any laws passed by the EC and at the EU level must be respected by all member countries and in fact supersede national laws.

However, there isn’t a strong fiscal function at the EU level, meaning that they cannot provide public goods or large amounts of spending for the purpose of redistribution etc. All spending items are essentially member states competencies. Although the EU has a budget and supports innovation and regional development to increase cohesion throughout the region, the most significant spending functions are all within a national context. The EU budget is very small, amounting to 1.5% of the gross domestic product (GDP), compared to federal state budgets which range from 10%-20%.

Challenges faced by EU

Three issues are being addressed simultaneously, reflecting recent developments over the past three or four years.

Traditional horizontal industrial policy in the standard model focuses on improving the framework conditions for all firms to bolster innovation globally. In economic literature related to decarbonization, due to the presence of “path dependencies” in innovation, there is an argument for promoting specific sectors and firms, in this case in the direction of “clean tech,” due to their increased chance of making new discoveries in that field and related fields, rather than more horizontal policy.

The next issue is economic security, fueled originally by increased concerns about China. The EU was the last of the three closely allied trade partners—the EU, Japan, and the U.S.—to perceive China’s potential threats, with Japan having been the first of these regions to experience hostility from China with the rare earths embargo from 2010.

The cut-off from Russian gas also raised concerns about economic security, as relying on imports from a potentially hostile country can have severe consequences and Europe has learned a hard lesson about complacency on this front. However, the impact of the cut-off was not as severe as anticipated.

Economic nationalism

Finally, economic nationalism in advanced competitor countries such as the US has influenced policy reactions. The Biden administration, despite being more internationalist-minded and friendly towards Europe and Japan, has retained some of Trump’s economic nationalism in trade. The IRA aimed to implement discriminatory industrial policies against foreign producers, both directly and indirectly.

China’s aggressive subsidies to its industry represent another concern in terms of economic nationalism as it obviously intends to use its subsidies to destroy other markets and thereby to take them over.

Concept of economic nationalism

Economic nationalism involves policies with state involvement, but should not be confused with state intervention, which differs in both its focus and role.

Statism, or state intervention, is the belief that state control over economic activity is necessary. This control ranges from a fully free market—a classical liberalist ideal—to complete state control in planned economies. Even in a single-country world, societies would have to determine the extent to which a state should manage the economy.

Economic nationalism is defined by the view that there is strong trade-off between national and foreign economic interests. The philosophy believes that policies that promote domestic prosperity must come at the expense of foreign prosperity. Protectionism is an example of economic nationalism that protects domestic firms against foreign ones, benefiting domestic workers and companies, while negatively affecting foreign workers and firms. There is no win-win.

Arguments for economic nationalism

The ideology of “my country first” reflected in Donald Trump’s “America first” view emphasized policies in which the U.S. must advance its well-being by pursuing policy actions that harm other countries and foreign firms.

Economic nationalism is a long-standing question in economics. The liberal economic tradition originating in Scotland argues that countries pursue wealth through open borders and international trade is in sharp contrast to the opposing tradition which emerged around the same time, which was based on countries that were striving to develop in the face of a ruling empire.

The British Empire imposed its own trade rules and preferences on the rest of the world, and Alexander Hamilton, the first Secretary of the U.S. Treasury, emphasized the importance of developing manufacturing industries in the U.S., which required active state intervention to support American firms at the expense of British competition. This perspective was shared by German economist Friedrich List and was reflected in the “Japanese developmental state” of the 1950s and the 1960s.

This type of economic nationalism is justified, because it is simply the intervention of the state to ensure that its country is on a level playing field with the most advanced nation/technological framework of the time.

The intellectual foundation for engaging in economic nationalism in advanced countries is much less certain because those nations already have a strong production foundation. They must decide whether to adopt protectionism or embrace open and free trade as they already possess production knowledge.

Most economists advocate open trade in countries for benefits such as access to cheaper goods, resulting in overall welfare gains.

Counterarguments against economic nationalism

Rent protection is a concept in which one part of the world exploits another by selling goods at higher prices owing to their unique skills or knowledge.

There is another politically popular view which posits that certain jobs, particularly manufacturing jobs, are superior for workers because of their ease of unionization and unique sociology. Under this view emerging markets would normally absorb those jobs as advanced countries focus on services and innovation, but those segments of the economy should be protected. This argument has driven the political economy of economic nationalism in advanced countries, which was embraced by Donald Trump and Joe Biden.

The third argument argues that economic nationalism and national security intersect and suggests that countries with lagging technologies may pose a threat, including militarily unless a certain lead is maintained in specific technologies. While this is not a blanket justification of economic nationalism, it does justify security-focused nationalism in specific sectors.

Unresolved issues

First, from a global perspective, all countries face worsening effects of nationalist foreign economic policies, with only a few exceptions. Temporary nationalist policies, such as those of Japan in the 1950s or the 1960s may be justified, as they benefited the entire planet by turning Japan into a sophisticated and prosperous producer of goods.

Second, economic nationalism is also vulnerable to special interests, as some firms argue that they need protection for the sake of society. However, these firms may be inefficient and destined to fail, making protectionist measures unfavorable from a national perspective.

Finally, economic nationalism and economic security can sometimes conflict, as achieving economic security may require international strategies that impact allies even if the primary focus is not on them.

Wealthy nations with strict nationalist economic policies may struggle to convince the international community to align with them and engage in fair-trade agreements, which itself may create a security threat.

The EU’s response to economic nationalism

The EU’s response to the economic nationalism of the IRA was influenced by China’s perceived threat and the experience related to Russia following Ukraine’s invasion.

The EU-level laws were sent to the European Parliament in the form of three policy instruments and two legislative proposals. It is possible that Commissioner Breton introduced the Critical Raw Materials Act (CRMA) and the NZIA, which were written by director generals under his supervision. These suggestions are currently under investigation.

The Temporary Crisis and Transition Framework for State Aid is a communication from the Commission outlining its intentions to implement State aid in light of the IRA and Ukraine invasion rather than a law.

The NZIA, CRMA, and State aid frameworks prioritize specific technologies and raw materials, identify economic activities of greater significance, and create lists for promotion. Similar to the IRA, these acts generate lists of recommended technologies for promotion.

The NZIA and CRMA have set additional objectives for reshoring or self-sufficiency in clean technology. The IRA does not include the requirement that 40% of all clean technologies used in the U.S. be made here as well. These actions target self-sufficiency, which is both flexible and aspirational. It is important to keep these objectives in mind, but not legal violations, if they are not achieved precisely.

The CRMA also aims to reduce the dependency on any single country to 65% or less by promoting its own raw materials, value addition, and extraction. The remaining percentage should come from other countries; however, it does not have to be produced locally. The NZIA focuses on self-sufficiency.

The legislation also seeks EU members states to support projects promoting objectives using policy instruments, such as the acceleration of permitting. These administrative procedures prioritize projects involving technologies and raw materials, with the aim of improving overall project success.

Member states are also called to prioritize security and sustainability criteria in public procurement projects, focusing on projects that improve the EU’s domestic production capacity through critical technologies. However, this preference has limitations, because countries cannot allocate significant fiscal resources to more expensive procurement without adequate funds and the EU lacks the financial resources required to pay for such action in each nation.

Members states can use state aid to promote critical activities and technologies within certain limits. If a third nation (the U.S.) attempts to entice a company to relocate its production to their shores, the European Commission authorizes member states to reciprocate by providing financial incentives to remain in the EU, provided they meet specific conditions, such as benefiting multiple members states or addressing economically disadvantaged regions.

This is a compromise between subsidy competition and harm to other European countries. The aim was to strike a balance between the two perspectives.

One final point is that none of the European responses to IRA violates the WTO rules, unlike the IRA. Pressure from France to imitate “America first” or “Buy American” policy with “Buy European” policy did not materialize in these laws, as there were no local content or assembly requirements.

Disagreement with this approach.

Bruegel essentially disagrees with the approach that has been taken, supporting some of the objectives, but disapproves of its implementation.

Problems with the approach

This approach lacks technology neutrality, and it would be better to promote any decarbonization or resilience technology or projects in general over predefined ones; however, it would be necessary to achieve stronger central governance, with decisions made on a discretionary basis over which projects to promote. This would be accompanied by its own series of issues, which is perhaps the reason that the list approach was adopted, but the current method is costly.

The second point is that the instruments in place are weak. There is no EU-level funding and the main tool in place is permitting, which is perhaps not very effective in regulating manufacturing and clean industry. Requesting members states to accelerate permitting may not yield significant results.

The third point is that this Act is protectionist in spirit, if not in actuality. This is a form of import substation with the goal of re-shoring, similar to policies in Latin America and East Asia after World War II. However, as the EU relies heavily on international trade, particularly affordable imports, for competitiveness, this could harm our capacity to effectively compete in export markets.

The NZIA strategy of increasing costs by substituting away from low-cost imports could hinder decarbonization efforts rather than accelerate them by increasing overall costs. Also, an EU-focused nationalist strategy could hinder international cooperation and production and promotes a narrow focus. Subsidies allowed under a state-aid framework can hinder intra-EU competition in the single market and divert attention from the structural reforms aimed at enhancing competitiveness.

General alternative

The traditional model cannot address certain challenges; therefore, it is crucial to adopt a perspective that maintains its advantages, while acknowledging its limitations. This involves choosing policies that avoid conflicts between trade-offs, such as an open, trade-oriented model for growth and efficiency and a focus on specific technologies and economic security for decarbonization.

Horizontal single-market reform is a policy that does not involve a trade-off between these objectives, including union of capital markets, skill strengthening, banking union, and energy policy, which would benefit all industries, with a particular emphasis on the clean tech sector.

Also, the definition used for economic security underling these legislative pieces is based on current trade patterns, such as the EU’s dependence on China and imports from other countries. However, they overlook the ability to adapt to and substitute away from these patterns in the case of a crisis and this type of analysis would be very beneficial.

The EU should avoid economic nationalism, as it hinders decarbonization, growth, and the broader EU foreign policy instruments, unless it is narrowly justified by a security argument. There are three arguments for economic nationalism in advanced countries, but only one argument is acceptable. Recent data does not support the “good jobs externality” argument for manufacturing jobs, as noted by a recent article in The Economist, so in the end, only the technological sovereignty argument is valid.

Adopting a vertical industrial policy that benefits specific technologies, prioritizing sustainability and resilience objectives and ensuring technology neutrality while protecting competition in the single market is recommended. In order to succeed, this requires strong EU-level governance and funding that will enable effective discretionary decision-making backed by serious incentives.

Enhancing the NZIA involves revitalizing single-market reforms and establishing a dedicated EU-level industrial policy agency with independent funding.

Comment

TAMURA Akihiko:
Dr. Zettelmeyer emphasized the importance of minimizing the trade-offs among GDP efficiency, decarbonization, and economic security in global commercial settings.

Economic nationalism promotes domestic sector interests at the expense of international ones and includes punitive trade measures and is necessarily inward-looking.

On the other hand, economic security is not, because it would be achieved through alliances with like-minded countries. However, in order for us to avoid any confusion to the distinction between economic nationalism and economic security, we need a strong legal trade regime with a reasonably functioning dispute settlement mechanism. Otherwise, we could not decide whether respective trade measures are unjustified as serving economic nationalism or justified as serving economic security. For this purpose, a legal regime backed by a reasonably functioning dispute settlement mechanism is necessary.

For the purpose of economic security, we also need more like-minded partners, particularly emerging economies and developing countries. Strong legal trade regime serves this purpose as well. Japan, the EU, and the U.S. are large enough that they would not be catastrophically affected by unpredictability, which would be caused by a lack of the strong legal trade regime. However, the smaller trade partners are unable to cope with such uncertainty. Therefore, reinforcing a legal trade regime would provide such support to these smaller partners, which could help us extend our network of partnership, which would then enhance our economic security.

Therefore, the EU and Japan should prioritize persuading the U.S. back into the position more affirmative to such a legal trade regime which the US currently gives cold shoulder to. The recent news that the U.S. and the EU have agreed on the data protection adequacy of the Data Privacy Framework, seems to me to be a hopeful sign of what may be possible, despite the recent strained transatlantic relationship, which can be observed in the context of US IRA and the EU response to it.

Q&A

Q:
How does the EU see Japan as a partner compared to China and the U.S.?

ZETTELMEYER:
At the EU level, China is often seen as a threat, whereas Japan is seen as an ally. However, there is insufficient recognition of the close alignment between Japan and the EU, and more efforts should be made to strengthen and promote this partnership.

Q:
Is economic internationalism not as susceptible to a special interest influence as is economic nationalism?

ZETTELMEYER:
Firms lobby to maintain international integration and special interests are therefore likely to attempt to influence most policies. Economic nationalism, which focuses on supporting domestic firms and preventing competitors from other countries, resonates with many domestic firms, except for multinationals and export-oriented firms.

Q:
Japan is discussing new strategies for industrial policies. Are there any highly rated foreign industrial policies outside of the EU?

ZETTELMEYER:
Japan and East Asian countries have been more successful in implementing industrial policies than Latin American or European countries. France’s industrial policy in the 1960s and the 1970s was widely regarded as a failure. The success of these policies has been debated, and Japan shifted away from economic nationalism in the 1970s once it had largely caught up.

The debate on industrial policy implementation in advanced countries is ongoing, and I am unclear on Japan’s intentions and models. but non-discriminatory practices are preferred because of the significant trade-offs. Successful examples include the Advanced Research Projects Agency and the Defense Advanced Research Projects Agency. Japan may have had similar success stories.

Q:
Any thoughts on autonomous driving or artificial intelligence?

ZETTELMEYER:
Highly regulated and socially protected industrial countries face challenges in innovation in risk-involved areas. Experimentation should be encouraged and made easier, whether it is seen as a technological competition with developing countries or simply for the purpose of promoting innovation for the benefit of all.

The German Ministry of Economic Affairs introduced “regulatory sandboxes” to experiment with autonomous vehicles, despite Germany’s safety-focused culture which made experimentation in autonomous vehicles daunting.

Q:
How can China be encouraged to adopt technology neutrality and create an industrial policy?

ZETTELMEYER:
Supporting technological neutrality is simply beneficial for competition, so it should be undertaken regardless of whether other parties implement it or not. Technological neutrality avoids the trap of trying to find the correct answer to a technological problem before the market comes into play. China should also do this. But it requires strong institutions and governance, which is lacking at the EU level. Japan’s strong institutions and governance make it easier to develop a robust, technology-neutral industrial policy than in the EU.

Q:
Any observations on energy security?

ZETTELMEYER:
Energy security is a major concern, with decarbonization facing political opposition from both right-and left-wing parties. Skepticism stems from concerns about social impact, marginalized communities, and negative effects on competitiveness and industry. Climate-friendly solutions involve the development of technology to increase the energy supply and lower prices, but time is needed.

German industries and politicians are interested in green hydrogen and similar initiatives which will allow for the current model of cheap energy imports. The alternative would be to import energy-intensive goods and shift parts of the value chain to regions with lower energy costs. EU-level financing is currently unavailable for the endeavor to simply force the shift to green renewables and green hydrogen etc. A stronger EU-level funding push could resolve the trade-off between decarbonization speed and energy cost acceptance.