DP18576 A Framework for Geoeconomics
Governments use their countries’ economic strength from existing financial and trade relationships to achieve geopolitical and economic goals. We refer to this practice as geoeconomics. We build a framework based on three core ingredients: input output linkages, limited contract enforceability, and externalities. Geoeconomic power arises from the ability to jointly exercise threats arising from separate economic activities. Being able to retaliate against a deviating country across multiple arenas, often involving indirect threats from third parties also being pressured, increases the off equilibrium threats and, thus, helps in equilibrium to increase enforceability. A world hegemon, like the United States, exerts its power on firms and governments in its economic network by asking these entities to take costly actions that benefit the hegemon. We characterize the optimal actions and show that they take the form of mark-ups on goods or higher rates on lending, but also import restrictions and tariffs. The input-output amplification makes controlling some sectors more valuable for the hegemon since changes in the allocation of these strategic sectors have a larger influence on the world economy. This formalizes the idea of economic coercion as a combination of strategic pressure and costly actions. We apply the framework to two leading examples: national security externalities and the Belt and Road Initiative.
