Confronting Fragmentation – three challenges for Australia*

Address to the Australian Institute of International Affairs

Dr Heather Smith

Canberra, 11 November 2024

Thank you, Aunty Violet, for that warm welcome to country. Allow me to pay my respects to elders and acknowledge all Aboriginal and Torres Strait Islander colleagues here with us today.

Shadow Minister for Foreign Affairs, Senator The Honourable Simon Birmingham;

Dr Shashi Tharoor, MP;

Your Excellencies, Members of the diplomatic corps;

Distinguished speakers, panellists and guests.

I would also like to acknowledge former President of the AIIA, John McCarthy,

the AIIA Fellows here today and my fellow AIIA board directors.

Though she is not here today, I would particularly like to acknowledge and thank our retiring Tasmanian President, Kim Boyer, for her outstanding contribution and commitment to furthering the mission of the AIIA both in her home state and nationally through her role on the AIIA board.

Nearly a week on from the US election you might expect that my opening remarks would be directed to the implications of that momentous result for Australia. We will hear much on this from what promises to be a robust exchange of views from our panellists today, and from Treasurer Jim Chalmers tonight.

Instead, November 2024 has led me to reflect on the past decade and beyond – what has irrevocably changed, and what lessons we need to heed as we navigate a world that is fragmenting.

Not necessarily deglobalizing, but definitely reconfiguring, and fragmenting in terms of global political, economic and trade linkages.

Ten years ago this week, G20 leaders, along with the heads of the Bretton Woods institutions, convened in Brisbane under the Australian Presidency, led by then Prime Minister Abbott.

I was the Sherpa, the Prime Minister’s personal envoy, charged with delivering Australia’s policy priorities, balancing these with the interests of other members, and somehow bringing all this together with the other 19 members such that we would have a successful summit.

I can say, honestly, it was the most complex and stressful role I have ever had!

Looking back I can see, from my months of intense diplomacy, the indicators that we were approaching an inflection point in geopolitics.

The United States was becoming increasing transactional in terms of its interactions with others. Perhaps more importantly, it was misreading the room in terms its relative economic and strategic position.

But it wasn’t the US alone that was seemingly blind to change. I recall at one of the sherpa meetings I chaired, how the rest of the G20 bristled at having to wait for the G7 to finish their side meeting before returning to the big table.

It may seem odd today, but China was playing a constructive role, while also aggressively positioning itself within global institutions and with developing countries through its then recently announced Belt and Road initiative.

It seems astounding now to think that after the Brisbane summit President Xi Jinping travelled to Tasmania – the only state he hadn’t visited since his first of several trips beginning in 1988 – and then addressed the Australian Parliament.

As an aside, even today no current Australian politician has the same understanding of China that Xi has of Australia.

Also in 2014 the BRICS were beginning to caucus, but they were dismissed as having far less in common than they claimed.

The multilateral institutions still had policy influence, but resentment was building as reforms to their mandates and representation proceeded at a snail’s pace.

This was not new – it was the latest development in a trend that had started in the 1990s and accelerated after the Asian Financial Crisis as the small European nations, who’s representation was and remains disproportionate to their importance in the global economy, prevented serious reform of the Bretton Woods institutions.

Geostrategic and global issues were seeping into the G20 agenda – Ebola had broken out in Africa and the downing of MH17 had invoked Abbott, perhaps sensing earlier than most, to blame President Putin for that tragedy. As you may recall, Abbott planned to ‘shirt front’ Putin at the summit – who knows what that meant, but perhaps the world would have been better off if he had!

Surprisingly to many today Australia then was seen as a trusted partner to most. We moved comfortably between the developed and developing world. We didn’t bring ideology to the table. And we’d played this role for half a century.

Looking back:

• 2014 was the last year the G20 would retain its cohesiveness on international economic cooperation.

• Indeed, 2014 is now clearly seen as a turning point or, perhaps more accurately, the point when we realised the world had changed.

No one today is under any illusion we are going back to the optimism of the 1990s and 2000s, or even the pragmatic cooperation of the early 2010s.

The new Cold War axes are increasingly clear, while the prevailing economic paradigm of the early 2000s has gone.  The sense we were all on the one page disrupted earlier, perhaps proximately with the Global Financial Crisis, but was fraying even before that.

Looking further back, thirty years ago this time of the year, I was getting ready to submit my PhD thesis. My thesis was on the role of government in the industrialisation of Taiwan and South Korea.

My supervisor was Ross Garnaut – one of Australia’s greatest economists. As Bob Hawke’s economic advisor, Ross was one of the key architects of the opening of the Australian economy and the prosperity that followed.

He had written extensively of the perils of protectionism for Australia given our size, history and geography. He went on to author the landmark report for Hawke that set out why Australia’s future lay within Asia and how open regionalism would underpin our next wave of prosperity.

My thesis focussed on strategic industry policy.

At the time there was a vigorous academic and policy debate about what had driven North Asia’s rise and the fear this had induced in some countries, particularly the United States.

My research concluded that Taiwan and South Korea had succeeded despite, rather than because of, government intervention.

Where government had successfully intervened, it had been clever, targeted and temporary. Government and business had worked in partnership, backed by a highly skilled workforce.

Above all, macroeconomic policy frameworks conducive to growth, and an open trading system underwritten by the US, underpinned their success.

As an aside, this was the exact opposite of Australia’s history of government intervention – the `protection all round’ mantra that had seen Singaporean Prime Minister Lee Kuan Yew warn in the1980s that we were on the way to becoming the poor white trash of Asia, and then Treasurer Paul Keating describing us as being on the verge of becoming a banana republic.

In contrast to the complacency that had become the norm in Australia in the 1960s and 70s, the so-called Asian Tigers, surrounded by unresolved strategic tensions in North Asia, saw economic growth as a key strategic imperative.

Fast forward to today, those strategic tensions have now evolved into great power rivalry between the US and China that evokes fears of a return to the Cold War and worse.

But in contrast to the Cold War, the region in which we live is the epicentre of this competition. And unlike the Soviet Union, China is integrated into most of the global supply chains that have driven Australian prosperity in recent decades.

Looking more broadly, notwithstanding decades of supposed effort, the Middle East remains a seemingly intractable vortex of conflict and despair.

Russia’s war of aggression against Ukraine continues.

Combined with the emergence of far-right parties as potentially governing entities of Western democracies, evoking fears of ethno-nationalism not seen since World War II, this has thrust us into a set of circumstances I think none of us could have imagined twenty years ago.

As the UN Secretary General has put it, ‘our world is in a whirlwind’…’having lost the hot lines, red lines and guard rails of the Cold War’.[1]

Most stark is how national security is transforming economic policy.

Intervention in markets to avowedly build competitiveness, resilience and de-risk dependencies is the norm in the US, China, and the EU.

Evidence of global fragmentation is appearing as economic integration weakens and economic policy becomes weaponised.

The IMF says more than 2,500 industry policy interventions were recorded last year with China, the EU and US accounting for around half of that total. Most of these interventions were driven by concerns over strategic competitiveness, climate change and supply chain resilience.[2]

President Xi’s prioritization of national security and self-reliance over economic growth and living standards has given rise to a Chinese economy now looking seriously unbalanced, raising concerns whether it can remain a stable engine of global growth.

The clean energy transition is now a geopolitical scramble to secure transformative technologies.

These sorts of policies have real, but often unintended impacts.

Trade relations and sectors are being reshaped as trade flows are re-routed. China’s export drive, as it tries to revive its economy and redirects exports to avoid US measures, is creating tensions with both developed and developing countries.

We are beginning to experience periodic episodes of global oversupply and slumps in sectors now considered strategic such as electric vehicles, batteries, semi-conductor chips and critical minerals.  Australia, as a price taker for some of these sectors, should expect more price volatility and more bouts of supply driven inflation and deflation.

The recent plunge in nickel and lithium prices, along with calls to create parallel markets, should be an early salutary lesson in just how distorted markets can become when national security is the dominant objective.

As China and the West struggle for primacy in areas and fragment supply chains, none of this portends well for the poorest countries.

A quarter of humanity will be the biggest losers from this fragmentation.  The World Bank has described this as the ‘great reversal’. [3]

Brutal clarity about the underpinnings of success

In Australia, several trends have intensified since we gathered here a year ago.  Most notably, the extent of government intervention in the economy, the persistence of inflation and cost-of-living pressures, falling real per capita incomes and weak productivity growth.

And over the last twelve months our social cohesion has also taken a terrible battering – from the `Voice’ referendum into the emergence of unanticipated deep-seated anti-Semitism, and the on-going Islamophobia that has gripped us for some-time.

Looking ahead, Australia is now trying to re-engineer markets where government judges price signals have failed to attract sufficient private investment in the areas of renewable hydrogen, green metals, low carbon liquid fuels, clean energy manufacturing and critical minerals.

Let me be clear – I am not in the camp that argues we should not do this. To the contrary, our strategic circumstances demand it.

We are more vulnerable.  And it’s unrealistic for a mid-sized economy dependent on global markets to sit this frenzy out.

But if not carefully handled we can easily erode, not enhance, our competitive advantages and undermine our long-term prosperity and security.

Interventions that incentivize new sectors should always be preferred over those that protect declining ones.[4] If we are really interested in new economy opportunities and strategic interventions, we should not lose sight of this.

However, for Australia, the danger is that we don’t learn from our own past. It has taken decades for assistance to be wound back in those sectors that show no sign of making it on their own. As a former Secretary of a department with responsibility for industry, innovation, science and resources, I know first-hand how hard it is to wind back policy interventions.

Even if we avoid the worst of protectionist outcomes, this intervention will come at a cost.

Having multiple and loosely-defined goals – whether to create manufacturing jobs, build national capacity, promote national security, or accelerate the clean energy transition – will be a difficult balancing act for a country like Australia that lacks the scale and market power of others.

There will be wastage of public expenditure and the displacement of capital and labour from more productive uses.

The key lesson from history, and the first necessary challenge for Australia to navigate in a fragmenting world, is that for industrial policies to be potentially effective they must be accompanied by a suite of smart polices and enablers – a strong private sector and a credible macroeconomic framework.

As Australia also engages in interventionist industry policy we must be ever vigilant about whether we are backing long-term economic winners and building competitive advantage or entities that, while strategically critical, may never be economically viable.

If we confuse the two, we risk underinvesting in strategically critical areas and over investing in what economists euphemistically call infant industries.

Brutal honesty and clarity about why we are investing in particular sectors, and where in those sectors, is absolutely critical to our chance of making those investments a success. And to avoid repeating the mistakes of the past.

How we make decisions is as important as the decision themselves

The second necessary challenge is that our policy making apparatus must be better configured for the times. As Australia’s strategic circumstances have deteriorated, the boundaries between national security, foreign policy and economic policy decision making have blurred.

Yet too many strategists and economists act as if they are in separable domains.

Sensible analysts have always realised that economics and national security cannot be separated areas.

Economists have to recognise this, after a long period of having ruled the roost.

And strategists have to realise they have no assets to strategize over unless we are economically successful.

Having straddled both domains over many years, my own view is that economists have either been naive or rather late to recognise just how much our strategic circumstances have deteriorated.

At the same time, strategists need to start listening to economists and stop seeing the economy in mechanistic terms.

Because what economic thinking does is help sift through, and prevent, partial views of the world dominating.

And though economists have never been that good at understanding power, strategists tend to view the world as black and white and engage in broad sweeping narratives. They are less focussed on the interdependencies, trade-offs and unintended consequences beyond defence spending and planning. What success looks like, or the aftermath, is rarely defined or planned for.

Some have even suggested economists have little to contribute when it comes to geostrategic competition and conflict.

This should be tempered by the history of post-conflict reconstruction.

I don’t like to think of it this way, but to invoke an image from Pulp Fiction, economists are both Mr Wolf, the cleaner, and then the rebuilders/redevelopers of the mess left behind.

Delving further back into history, I suspect many would not recall it was the economists like Nugget Coombs and Sir Roland Wilson who played critical roles in keeping the economy afloat and providing the resources needed through World War II.

The closer integration of our economic agencies with our intelligence and security policy agencies to support economic and national security decision making is something Richard Maude and I paid close attention to in our independent review of the Australian Intelligence Community commissioned by the Prime Minister last year.

While our policy community and national security agencies are working well together, deeper integration and co-joined agility are needed.

This is especially important for the economic agencies where national security threats are becoming more challenging to manage.

This is most obvious in foreign investment, telecommunications and technology policy deliberations but now extends to all areas of the economy – infrastructure, industry, resources, climate, energy and health policy.

New and systematic approaches to decision making and governance are also needed. The Treasury’s National Interest Framework, if embraced, represents a good attempt to strike the right balance between our national and economic security.

Regardless of who is in government, it will be important such frameworks are not politicised, but rather are used with integrity and discipline.

In this challenging world, government should expect the policy advice it receives to be principles-based, to be coordinated, contested, risk mitigated and situated within the broader context of the national interest.

While we hope for the best, we need to be prepared for the worst. This creates an imperative for our economic and security agencies to work ‘hand in glove’ close together.

A gimlet-eyed approach to national interest

Other countries’ approaches to economic security are also creating complex policy choices for us. With our major trading partner and our most important strategic ally locked in enduring competition, the actions they are pursuing in the name of their own economic and national security will not always be in Australia’s interests.

The third necessary challenge is how we balance our national interests given our ultimate alignment with the US and our economic engagement with China.

While Australians may intuitively understand that we will almost always align with the US in a crisis, based on our common values, we may also wish to retain strategic and economic manoeuvrability as we pursue our interests.

That means the US accepting that we will, at times, need to chart our own pathway, notwithstanding that we and they know where we are standing when the chips are down.

This is increasingly important if, as it seems likely, the ‘small yard, high fence’ of national security will now expand to be a ‘large yard, high fence’ as the technologies and infrastructure that underpin global living standards become more decoupled. In that event, as Michael Spence has said, ‘we are then talking about a direct, sweeping and hugely costly assault on a vast swath of global trade, investment and technology transfer’. [5]

Peter Varghese recently challenged us, as only he can, and with the brutal clarity that I spoke of before, by saying that the retention of US primacy is not a vital Australian interest. What is in our national interest is ensuing US leadership and engagement in the Indo-Pacific and that it remains the lead balancer of China.[6]

The conundrum that will challenge Australia like never before is that the US, which developed the international system in its image, will now not lead or engage on the necessary renovation of the rules and institutions required for the 21st century. Indeed, the US will now be the accelerator of global fragmentation as it becomes more isolationist, seeks to thwart China’s growth with trade restrictions, and retreats from multilateralism.

As Allan Gyngell and I wrote at the time of the pandemic, in this new world order, in which economic convergence is over, Australia has a key role in preventing the world from drifting into ‘beggar thy neighbour’ policies of the 1930’s.[7]

Preventing such an outcome will not come from a single source of power. It requires like-minded countries to create partnerships and work together as a networked grid to provide ballast to the regional and international economic order. As Anne-Marie Slaughter recently put it, ‘a multi-partner world is not a mushy vision of global harmony. It is a necessary precondition for survival’.[8]

Conclusion

Last year Treasury’s Intergenerational Report laid out that Australia’s living standards over the decades ahead are dependent of how we respond to five forces: population aging, deployment of technology, the net zero transformation, the transition to the care economy and our geopolitical environment.

There is yet no national consensus on how to manage these big shifts nor public understanding of the tradeoffs ahead in national security, economic prosperity and social cohesion.

The necessary conditions to manage the challenges I have outlined today just aren’t present. That is, a political consensus on the way forward, community and political trust in detailed policy work, and the political class’ collective capacity and willingness to engage with citizens as to what is in the national interest. The absence of these conditions, and the rise of social media, have facilitated the organized resistance of vested interests to needed reform.

Like other Western countries, this is a manifestation of a deeper issue – the fragmentation of national unity and identity.

It feels like Australia is in unchartered waters.

As some have pointed out, our strategic and defence policy presumes that we have picked a side in the great power rivalry and are putting in place the building blocks with allies and trusted partners.

Our economic security roadmap is now much less clear.

For all the focus we have now with the US on defence and technology policy, we should not be under any illusion that our economic and trade interests will be given a carve out in the event of a crisis involving China.

They will not.

This reinforces what I said two years ago in my Plimsoll Lecture – that raising our growth and productivity performance should be just as urgent an undertaking as our defence planning.[9] With national and economic security now inextricably linked, substantive reform to drive growth is needed to survive in this era of fragmentation.

This is not the era for incrementalism.

The policies needed to do this are well documented.

At some point this all needs to be squared-up with the Australian people.

We need a national conversation that doesn’t shy away from the realties and the choices that must be made.

On that sober note, and on this important day that is Remembrance Day, let me open our day of reflection and discussion.

Thank you.

* This paper has benefited from discussion and assistance from Dr Martin Parkinson.

[1] United Nations Secretary-General Antonio Guterres address to the opening of the seventy-ninth session of the General Assembly, New York, September 24, 2024.

[2] Simon Evenett, Adam Jakubik, Fernando Martin, Michele Ruta, The Return of Industrial Policy in Data, IMF Working Paper, January 2024.

[3] Tommy Chrimes, Bram Gootjes, M. Ayhan Kose, and Collette Wheeler, The great reversal, International Bank for Reconstruction and Development / World Bank, 2024.

[4] Danny Leipziger, Emerging economies and smart industrial policies, Financial Times letter, May 8, 2024.

[5] Michael Spence, The high cost of excluding Chinese technology, Project Syndicate, October 2, 2024.

[6] Peter Varghese, The unresolved tension at the core of Australia’s strategic policy, Australian Financial Review, 9 October.

[7] Heather Smith and Allan Gyngell, Virus demands a call for a new world order’, Australian Financial Review, 23 April p.36-37.

[8] Anne-Marie Slaughter, How America can succeed in a multialigned world’, Foreign Affairs, 30 October, 2024.

[9] Heather Smith, The decade ahead: disruptive, disorderly and dangerous, Address to the Australian Institute of International Affairs, 13 November 2022.