Geopolitical Tensions, Social Identity and the Fragmentation of the Global Economy

Geopolitical tensions threaten to fragment the global economy into rival blocs. As a driver of this fragmentation, we propose a demand-side channel grounded in social identity theory: consumers value goods partly by the political and economic values embodied in their origin. We embed this in a trade model with two countries that are similar in terms of political values and one dissimilar country, with the US, the EU and China as our benchmark example. We show that a geopolitical shock raising the salience of political over economic values diverts trade toward the similar pair and can also make a previously unattractive standards-harmonization agreement between them mutually beneficial. A subsequent estrangement of the similar pair, through diverging political values or trade-war measures, can reverse both effects and push the world economy from two blocs toward three. We also apply the framework to an estrangement of the US from the EU and Canada. Both a US divergence in political values and trade-war measures divert trade toward the EU-Canada pair, but only the former can make a previously unattractive EU-Canada agreement mutually beneficial.