A subsidy war without winners

After the "currency wars" of the previous decade and the "trade wars" unleashed by former US President Donald Trump, a new kind of conflict is emerging between two of the world's leading powers. Or at least that was the talk during the World Economic Forum in Davos, where pundits and policymakers fretted over so-called "subsidy wars."

The first shot was fired with the United States' passage of the Inflation Reduction Act (IRA), which includes $369 billion in subsidies and tax benefits for American companies using green technologies. In response, European Commission President Ursula von der Leyen promised to loosen the European Union's rules on state aid, enabling member states to pump cash into green industries. "To keep European industry attractive, there is a need to be competitive with offers and incentives that are currently available outside" the EU, she said, at pains to defend the bloc's protectionist turn.

To be fair, those concerned about the costs of a European-American subsidy war are mainly academics. Businesspeople dislike subsidies only when they are not receiving them. "It is a game-changer," I heard a tycoon say about the IRA. He added that his company recently decided to launch four mammoth green investments in the US and would consider doing the same across the Atlantic if the EU put enough money on the table.

With the recent US and European moves, the green subsidy debate is heating up. Proponents of these policies describe them as an indispensable response to the existential threat of climate change, while skeptics claim that the massive deployment of resources will inevitably lead to rent-seeking and inefficiency.

The issue is not whether governments should subsidize environmentally friendly industries. It is widely acknowledged that because the social returns on green investments exceed the returns that accrue to private firms, governments must provide financial incentives to prevent under-investment. Instead, the issue is whether governments should offer those incentives only to domestic companies.

In Davos, von der Leyen called on President Joe Biden's administration to grant European companies operating in the US access to the same subsidies as domestic firms. But in the unlikely event that Biden agreed, that would still put the rest of the world at a disadvantage. If an electric car assembled in Michigan by an American company yields the same emission savings as a similar car assembled in Seoul by a South Korean company, why subsidize one and not the other?

There are at least three reasons why a subsidy war could be economically harmful. The first is retaliation. While green subsidies could encourage more investment, they could also entrench inefficient incumbents. If the US and the EU cooperatively decided on the level of subsidies, they would choose what is "right" for both. But that is not the outcome in a subsidy war. One side's attempt to attract green investment triggers a reaction by the other side. The subsequent escalation of subsidies and counter-subsidies can cause costs to outweigh benefits.

The second problem is that what is good for Europe and the US is not necessarily good for the world. If the goal is to reduce global greenhouse-gas emissions, the planet might be better off if dollar and euro subsidies were used to buy cheaper Chinese solar panels. That way, the same expenditure would accomplish more emission reductions and lower temperatures for all of humanity.

The third risk is that a subsidy war might lead to a waste of fiscal resources. If long-term real interest rates in the US and the EU remain below their growth rates, as many eminent economists believe, then this is a non-issue, because governments can spend and borrow without having to raise taxes in the future. But if the era of low interest rates is over, then the huge fiscal cost of green subsidies should be a concern.

How big are these economic risks? No one can be sure, but there are reasons to take dire warnings with a grain of salt. For example, recent estimates suggest that Trump's trade war with China had a much smaller effect on the US economy than many had predicted, resulting in welfare losses of roughly 0.1% of GDP. And that war was fought with tariffs, which discourage trade, while subsidies encourage beneficial emissions reductions. In addition, eligibility for the subsidies depends on complex "domestic content" requirements that can be tweaked if they become too onerous.

Moreover, the economic impact of a US-EU subsidy war on the rest of the world will most likely be limited. Yes, firms outside the US and the EU might be harmed. But if green subsidies accelerate the clean-energy transition and help contain global warming, the whole world will reap the benefits.

The same goes for fiscal risks. Yes, both the US and the EU could eventually encounter problems if real interest rates continue to rise and stay high. But if and when that day comes, there are many other wasteful expenditures that governments could and should reduce before cutting green subsidies.

The more immediate risk is political. The US subsidies violate the World Trade Organization's rules prohibiting discrimination against products or firms based on their country of origin. The EU must not follow in Biden's footsteps. At a time of heightened geopolitical tensions, the world's leading democracies should aim to strengthen the global rules-based system, not undermine it.

Most importantly, a subsidy war would sour political and diplomatic relations between the US and Europe at the worst possible time, when liberal democracies face Russian aggression in Ukraine, Chinese expansionism, and illiberal regimes in Central and Eastern Europe, Asia, and Latin America. If we are to mitigate the worst effects of climate change, American and European policymakers must work together, instead of being consumed by petty squabbles over green subsidies.

Andrés Velasco, a former presidential candidate and finance minister of Chile, is Dean of the School of Public Policy at the London School of Economics and Political Science. He is the author of numerous books and papers on international economics and development, and has served on the faculty at Harvard, Columbia, and New York Universities. 

Disclaimer: This article first appeared on Project Syndicate, and is published by a special syndication arrangement.