‘Economic security comes at a price’

universal spotlight: The global economy is noticeably in upheaval. What do you see as our biggest challenges?

Professor Dr Moritz Schularick: We are now not only thinking about international networking but also about its risks and side effects. It is about dependencies, primarily on vital commodities as well as on China and other countries.

Economic security has become a key term and is an accompanying theme of globalisation. Economic security means ensuring an adequate supply of socially-defined basic needs even if the economic division of labour is disrupted. This can range from antibiotics to specialised chips.

To ensure this, supply chains can be diversified, warehousing increased, or production capacities built up in Europe. One thing is clear: economic security comes at a price. Costs arise for companies and societies, comparable to an insurance premium paid to be covered in case of an emergency - although you never know if and when this case may occur.

Do these challenges also apply to other economic regions?

China and the US are certainly posing the same questions, but different starting points lead to different answers. However, everyone is concerned about excessive dependencies and subsidising domestic production. In Europe, we have not yet fully switched to a policy that makes us completely independent of the US. Since we are still very dependent in terms of security policy, such a course would probably make no sense.

In China, as well as in the US, there are very clear efforts to become independent in critical areas. China’s strategy is evidently to reduce the strong importance of foreign trade as a basis for economic growth, and to develop its own technologies in areas such as chip production for artificial intelligence. America, on the other hand, has a far broader definition of the strategic areas it aims to shield from China’s influence.

A second major issue keeping companies and states worldwide on their toes is climate change and the climate transition it necessitates. Where are the focal points and differences in the various economic regions?

The US has rejected the idea of CO₂ pricing because it is assumed that it is not politically feasible. The approach is reversed: Subsidies are used to make green energy so cheap that it can compete with brown energy.

While CO₂ pricing is the more efficient approach, subsidies face less political resistance. In the end, everyone likes subsidies, including companies. However, it obviously costs the state more. This can also be seen in America’s fiscal policy. To finance subsidies, the US is prepared to increase public debt on a scale that is almost inconceivable in Germany and Europe. What happens in the US after the election in November is certainly a key question that remains to be answered.

On the other side of the Pacific, I believe China is the underestimated player in this game. Although CO₂ emissions in China have continued to grow in recent years, I believe that the extent of China's plan has not yet been understood in Europe and America. China's emissions are expected to peak by 2030 - perhaps even a little earlier - and then fall drastically. Underpinned by substantial state support and subsidy policies, China will probably focus most strongly on developing areas that are central to the energy transition in its own industry as sources of global growth. These areas are essentially solar and battery storage technology, and wind energy. Globally, this has already significantly increased capacities in areas such as solar panels and wind generators sectors, leading to lower prices. This makes renewable energies extremely competitive - at least when the wind blows and the sun shines.

And where does Europe stand in the climate transformation?

I think Europe is a bit of a problem child. The focus has been on CO₂ pricing and border adjustment taxes, but this has steered it into difficult political waters. The public has also shown considerable resistance to tackling the transformation in this way.

First, CO₂ certificates would have to become painfully expensive. However, this path might prove too rocky and arduous for our society, which is already struggling with significant polarisation trends, including issues like migration, demographic change, and so on. A little more pragmatism would do be beneficial. Currently, we are perhaps somewhat undecided and a little hesitant compared to the two other major economies. For example, we have developed many of these green technologies in Europe, but often fail to leverage them effectively as growth drivers.

universal spotlight: What can Europe do now? Where do you see the greatest potential for change?

It is not so much a question of money, but rather a question of instruments and implementation. An example: We rely heavily on funding programmes with considerable volumes. But the bureaucracy - which entails hundreds of pages of application forms, checks, and reporting requirements - means that you get little “bang for your buck”, so you don’t achieve much with the money.

In America, the instruments applied seem to provide a significant impetus. Take, for example, the widespread tax credits in the US. These are much easier to manage. They are of course less targeted and there are deadweight effects. But on the other hand, they actually get things moving. And the additional percentage points in growth may be worth more than this European fastidiousness that leads to a standstill. I would favour substantial innovation, ideas such as depreciation or tax credits that could perhaps even be invested, traded, or monetised. The main thing is that an entrepreneur who wants to fulfill a great project does not have to spend two months in a quiet room filling out application documents.

There is a second important point that we have been discussing for a decade now but where we have made very little progress: the capital markets union. Financing the energy transition requires a large capital market. And yet the mobilisation of private and institutional capital continues to be held back by around 20 less-dynamic national capital market structures. And this does not even include venture capital, which is less developed in Europe.

universal spotlight: And what are the key issues for Germany?

We are probably all aware by now that Germany is not ideally placed to offer competitive energy costs on an international scale. And we have not got many natural resources either.

Germany’s key issue is that if you do not have any natural resources, you must rely on the resource of intellect. Education, early childhood education, and schools are hugely important investment priorities. And yet, we continue to invest less than the OECD average. Our federal system places education - a crucial factor for national economic development – in the hands of states that are partly in a very weak financial position. Do we want to cling to plans devised about 75 years ago, or should we ensure that those responsible for the resource that will fuel tomorrow's growth have the necessary means for this? The required changes are highly complex – but manageable.

I think that another crucial factor is that we avoid making any mistakes with energy costs. A major error would be to use limited public funds to subsidise energy-intensive industries in Germany, knowing that these sectors will not be the growth drivers of tomorrow. In mature sectors such as the steel or basic materials industries, the end is already in sight, so subsidies would at best increase the companies' return on equity.

On the other hand, we must of course ensure, particularly in the current transition process, that our energy costs do not put us at a competitive disadvantage that hurts us in those areas where we still wish to have an industrial presence in the future. That said, energy costs play a lesser role in many areas. Energy costs are irrelevant for universities, for example, as well as for most specialised machine manufacturers where they only account for a low single-digit percentage share of production cost. Even in the automotive industry, only about three percent of added value is attributable to energy costs.

universal spotlight: Infrastructure is another key area that particularly concerns us here in Germany. Are we really at a competitive disadvantage in global comparison?

There is no denying that Germany is lagging in this respect if we compare the low levels of public investment with other OECD countries. Take, for instance, the sluggish expansion of fiber optic networks or investments in the rail network. Switzerland, for example, spends four times as much per capita - and they have not underinvested for the past 20 years.

Catching up is difficult, planning and construction capacities are finite. Although in the short term, one can certainly import tradable goods, such as construction services, as is happening. Fundamentally, the country’s strategy was focused on saving money, and now it is coming back to bite us. We were too hesitant to invest for too long –especially at a time when interest rates were almost zero for about a decade - and we could have financed so much at extremely favourable or even negative returns. In addition, by now we could have inflated away the debt by around 15 percent in two years.

One might shake their head. But now we have no choice but to become more agile and decisive when it comes to infrastructure and particularly, for example, to the expansion of power lines. Otherwise, we will simply not be able to accomplish the energy transition. The plan is to fully electrify the country in all aspects of mobility, heating, and energy consumption. There will certainly be a few exceptions here and there. Hydrogen may play a role in aviation, shipping, buses, or trucks, but power grids are indispensable for the transition in this country and elsewhere.

In all this, we have not even touched on another challenge: The public sector will have to spend significantly more on defense and security policy in the next ten years. Politicians need to consider where the resources for this should come from. We will have to reallocate budgets and also address social expenditure to invest more in security and transformation. This will not be popular. And with defense spending, it probably won’t happen overnight. We can’t just cut 50 billion euros from the federal budget to upgrade the Bundeswehr. But these are roughly the additional annual requirements.

universal spotlight: Where will the money come from in a tight budget situation if reallocating budgets won’t suffice?

The tasks are enormous. Given a net national debt of 45% of the gross domestic product, I currently don’t see how we can manage this in a macroeconomically sensible way without taking on additional debt, at least in the transition phase.

universal spotlight: Could private capital relieve public finances more than it currently does, as long as purely public responsibilities are not affected?

I think that is an excellent idea. Much more private capital needs to be mobilised, not just to finance innovation and provide venture capital, but also for classic financing in infrastructure.

If we increasingly use public-private partnerships for motorways, it’s crucial to ensure these models are genuinely attractive for both partners. Ultimately, the economic calculation is relatively straightforward: the efficiency in planning and implementation that comes with private financing must be significantly greater than merely offsetting the state’s financing advantage. And that is certainly the case in certain areas. If it is, we absolutely must pursue it. I would say that we can afford to be a bit more generous again, involving private capital a little more and making investments attractive for private investors. In the end, society has a lot to gain when key infrastructure is in place.

universal spotlight: Can and should (partially) private financing provide support all areas where financing gaps exist today?

There are certainly scenarios - especially in the healthcare sector, hospitals, and so on - where the outcomes haven’t always been entirely positive. Measuring the efficiency gains in managing a hospital is more challenging than those in managing a motorway or railway. What does “efficient” mean in this context? Does it mean providing the most comprehensive care possible for patients? This quickly becomes complex. However, where it makes sense, more private capital can be immediately utilised.

universal spotlight: One nevertheless gets the impression that other European countries are more open to involving private capital.

Many countries use these instruments more frequently than Germany– and often with the involvement of German companies. It’s quite possible that the social returns are significantly higher when private capital is involved. Take, for example, the social returns of a well-functioning airport.

From a social perspective, high returns for private investors do not indicate that something is wrong. On the contrary, my educated guess is that the state would benefit from focusing on its core tasks in the coming years, due to its much lower planning and management capacities compared to, say, 150 years ago under a Prussian administration. It doesn’t help to get tangled up in planning matters where private investors may have an advantage and where we can draw on their resources.

On the contrary, we should concentrate our limited state resources on truly critical areas such as education and healthcare. By limited state resources, I do not just mean money, but also the personnel and resources needed for planning and execution. Thus, we should focus on what is crucial for society and where there may be legitimate doubts that privately funded models make more sense. But tasks that can be managed by the private sector, such as infrastructure projects, should be handed over to the private sector as much as possible, and private investors should be involved to a greater extent.

universal spotlight: Both the public and private sectors are facing challenges, particularly with the transformation that requires significant investments from companies. What is the capital needed for?

When I speak with entrepreneurs, some aspects of climate adaptation are immediately understood: Everyone knows that solar panels are currently very affordable, and that it is very easy to install them on factory roofs. This allows them to use electricity relatively cheaply, and the prices for energy storage are now a fraction of what they were two years ago.

We will continue to see a lot of developments in adaptation, climate and energy transformation. We will certainly also have to invest in areas such as new material cycles. There is, in addition, a lot of demand in the automotive industry and the planning of mobility issues. Moreover, in areas where Europe is still quite well-positioned, such as industrial robotics, there is substantial need.

And there is certainly a huge demand for capital and investment in artificial intelligence - especially for many medium-sized companies. This ties back to the earlier point about investment in energy production and infrastructure: Overall, it seems to me that an underestimated issue is how the increased use of AI will shift energy demand projections in the coming decades.

In the US, estimates for energy demand are being raised monthly due to energy-intensive AI applications. In Germany, we still assume that our overall energy consumption will fall by about 30%over the next 20 years. I don’t understand how this is supposed to work. Either the forecast assumes that we will never use AI in Germany, or our reasoning is flawed. This makes the expansion of the grid even more urgent, especially as we are already struggling to keep up today.

Professor Dr Moritz Schularick has been President of the Kiel Institute for the World Economy since June 2023 and is Professor of Economics at Sciences Po University (Paris). He is also a member of the DFG Excellence Cluster ECONtribute and a full member of the Berlin-Brandenburg Academy of Sciences and Academia Europaea.

His research focuses on financial markets and asset prices, monetary macroeconomics, and the causes of financial crises and economic inequality.

He regularly advises central banks, finance ministries, investors, and international organisations.

Professor Dr Moritz Schularick is the recipient of the Leibniz Prize 2022, Germany's most prestigious research prize, awarded by the German Research Foundation (DFG).