Industrial policies are rarely connected to global imbalances. Yet, they are a key feature of many countries running persistent trade surpluses. Take the case of China. Chinese governments have invested heavily in industrial policies and intervened to suppress domestic consumption (DiPippo et al. 2022).  As a result, China has developed a massive trade surplus against the rest of the world (Setser 2025).  How to react to this ‘Second ‘China Shock’ is a key challenge for China’s trading partners (Pettis 2024).

Motivated by these facts, in this column we tackle three questions:

1. How do industrial policies shape global imbalances?
2. What are the spillovers to deficit countries?
3. What policy responses are available?

We focus on the impact of industrial policies and global imbalances on the international distribution of innovation and technological power. This perspective is particularly suited to understand the Second China Shock, which is affecting mostly innovation-intensive high-tech sectors.

A framework of industrial policies, global imbalances, and technological hegemony

In a recent paper (Cesa-Bianchi et al. 2026), we develop a framework connecting industrial policies, global imbalances, and technological development. Our model features two regions: East and West. Both regions produce a tradable good and a non-tradable one.

The first key feature is that the tradable sector is the engine of growth, that is, the innovation-intensive sector of the economy. This assumption squares well with the notion that high-tech goods and services are highly traded in the global economy. The non-tradable sector – think about construction and low-tech services – is instead characterised by stagnant productivity.

The implication is that the profitability of investing in innovation is higher in countries with a well-developed tradable sector. A larger tradable sector, therefore, is associated with more innovation and higher productivity. This positive relationship between size of the tradable sector (LT) and productivity (a) is captured by the GG schedule in Figure 1a. The downward-sloping RR schedule, instead, captures the notion that devoting more productive resources to innovation leaves less room for production of tradable goods.

Figure 1 The initial steady state

The second key feature is that global imbalances, and thus international capital flows, are determined by the demand and supply of liquid assets. In particular, households require liquid assets (b) to perform transactions, and their asset demand is increasing in the world interest rate (R). This is captured by the asset demand schedule in Figure 1b. Liquid assets are supplied by governments, and they correspond to the stock of government bonds (d). For simplicity, as shown in Figure 1b, we will assume that governments’ asset supply is constant.

How do industrial policies shape global imbalances?

Now imagine that the East subsidises its high-tech tradable sector, as part of its industrial policy. Naturally, economic activity in the high-tech tradable sector expands by attracting productive resources from the low-tech non-tradable sector. This is captured by the rightward shift of the RR schedule in Figure 2a. Moreover, a larger tradable sector boosts investment in innovation, and so productivity in the East rises over time. In the final equilibrium, the East has a larger tradable sector and is more productive. Both factors boost its national income.

Figure 2 Unbalanced industrial policies by the East

What about capital flows? Higher income boosts households’ demand for liquid assets, which is captured by the rightward shift of the asset demand schedule in Figure 2b. Given the inelastic supply of domestic liquid assets, households in the East end up purchasing foreign assets, causing capital outflows.

We have just described an unbalanced industrial policy mix, causing a rise in tradable output not balanced by a comparable increase in domestic demand. This unbalanced policy mix leads to trade surpluses, the natural counterpart of capital outflows.

What are the spillovers to deficit countries?

Let us now turn to the West. Higher demand for assets by the East reduces the world interest rate, inducing households in the West to borrow more. As shown in Figure 3b, the West thus develops capital inflows and trade deficits.

Now the interesting part. Higher foreign borrowing goes to finance a consumption boom in the West. Higher demand for domestic non-traded goods leads to an expansion of the non-tradable sector. Moreover, the exchange rate appreciates, reducing the competitiveness of the tradable sector. As a result, the West tradable sector contracts, innovation by firms in the West declines, and over time the West suffers a productivity loss. These effects are captured by Figure 3a, which shows how trade deficits induce a leftward shift of the RR schedule, leading to a drop in the production of tradable goods and in productivity.

Figure 3 Financial resource curse in the West

Effectively, the West suffers a financial resource curse (Benigno and Fornaro 2014, Benigno et al. 2025). This is similar to the notion of natural resource curse, in which the discovery of natural resources leads to an exchange rate appreciation and a contraction in the tradable sector. But here, rather than by the discovery of some natural resources, the curse is triggered by cheap access to foreign capital inflows.

Importantly, it takes time for the effects of the financial resource curse to materialise. The reason is that investment in innovation affects productivity only with a substantial lag. This point is shown in Figure 4, which displays a numerical simulation of our framework. The key aspect is that the impact of trade imbalances on productivity and GDP materialises gradually. Hence, while in the short run global imbalances may not affect economic activity by much, they can lead to substantial divergences in national income and technological power over the medium run.

Figure 4 Impact of industrial policies in the East on the global economy

Some empirical evidence

Is there empirical support for the effects we describe? In our paper, we take a first stab at this question by looking at the correlation between the use of industrial policies and several macroeconomic variables, in a sample of countries comprising both advanced and developing economies.

Figure 5 displays our key findings. First, the left panel shows that countries that relied more on industrial policies also experienced larger expansion (or smaller contractions) in their tradable sector, proxied by the share of manufacturing in employment. The right panel, instead, shows that industrial policies are positively correlated with productivity growth. Both empirical facts align well with the predictions of the model. Moreover, we find that, after controlling for standard macroeconomic factors, a positive relationship between trade surpluses and industrial policies emerges.

Figure 5 Industrial policy, manufacturing employment, and TFP growth

What about the financial resource curse? Benigno et al. (2025) show that episodes of large capital inflows are accompanied by a contraction of economic activity in the tradable sector and slowdowns in productivity growth. Moreover, Muller and Verner (2024) show that credit booms in the non-tradable sector are followed by declines in productivity growth. While just suggestive, this evidence conforms well with our theoretical framework.

Should the West worry about trade deficits?

The answer to this question is not obvious. On the one hand, access to cheap imports sustains consumption, which is good for welfare. On the other hand, the logic of the financial resource curse implies that persistent trade deficits may hinder investment in innovation. This effect may substantially depress national income and welfare, because it exacerbates the tendency of private firms to underinvest in innovation.
If this effect is strong enough, the drop in national income caused by lower innovation may outweigh the welfare gains from cheaper imports.

Moreover, technological leadership carries strategic benefits that go beyond standard economic returns. Countries at the technological frontier enjoy greater bargaining power in international negotiations, more influence over global standards and critical supply chains, and stronger resilience to economic coercion. Insofar as geoeconomic strength depends on technological power, the financial resource curse thus imposes an additional cost: by eroding its technological power, persistent trade deficits gradually reduce a country’s strategic autonomy in an increasingly competitive global economy.

Putting these considerations together suggests that deficit countries should worry about the financial resource curse. While this point seems to be well present in the minds of policymakers, there is much less agreement about the appropriate policy responses.

What policy responses are available?

The current debate is focused around policies that reduce trade deficits, and in particular on import tariffs (Miran 2024). But while tariffs affect gross trade, their impact on net trade and capital inflows is much less certain. Moreover, broad-based import tariffs may hurt innovation, by choking off the economy’s access to some key innovation inputs (Fornaro and Wolf 2025).

Policies that boost national saving, such as fiscal contractions or macroprudential policies, are more likely to reduce trade deficits and to reverse the financial resource curse. At the same time, if implemented by a large number of countries, these policies would depress global demand, and may plunge the world economy into a liquidity trap.

However, in our framework trade deficits are not a problem per se. The issue is rather that trade deficits may end up financing booms in non-tradable sectors – such as construction – with little scope for productivity growth, crowding out economic activity in high-tech tradable sectors. But governments can take measures to prevent this outcome, by subsidising economic activity – and especially investment in innovation – in the high-tech sectors that they wish to protect.  A number of interventions can fulfill this objective, ranging from industrial policies to more tailored innovation policies (public R&D, subsidies to private innovation, etc.). All these interventions can channel cheap foreign capital into productivity-enhancing investments, and thus reconcile trade deficits with healthy productivity growth. While our analysis represents just a first pass at this issue, it suggests that countries negatively affected by global imbalances should include industrial and innovation policies as part of their policy toolkit.

References

Benigno, G, N Converse, and L Fornaro (2015) ,“Large capital inflows, sectoral allocation, and economic performance,” Journal of International Money and Finance 55: 60–87.

Benigno, G and L Fornaro (2014), “The financial resource curse,” Scandinavian Journal of Economics 116(1): 58–86.

Benigno, G, L Fornaro and M Wolf (2025), “The global financial resource curse,” American Economic Review 115(1): 220–262.

Cesa-Bianchi, A, A Ferrero, L Fornaro and M Wolf (2026), “Industrial Policies, Global Imbalances and Technological Hegemony”, CEPR Discussion Paper 21253.

Diebold, L and B Richter (2025), “AD Two Become One: Foreign Capital and Household Credit Expansion”, The Review of Financial Studies.

DiPippo, G, I Mazzocco, S Kennedy, and MP Goodman (2022), Red ink: Estimating Chinese industrial policy spending in comparative perspective, CSIS Report.

Fornaro, L and M Wolf (2025), “Tariffs and Technological Hegemony”, CEPR Discussion Paper 20826.

Kalantzis, Y (2015), “Financial fragility in small open economies: firm balance sheets and the sectoral structure,” The Review of Economic Studies 82(3): 1194–1222.

Lucking, B, N Bloom, and J Van Reenen (2019), “Have R&D spillovers declined in the 21st century?”, Fiscal Studies 40(4): 561-590.

Mian, A R, A Sufi, and E Verner (2019), “How does credit supply expansion affect the real economy? The productive capacity and household demand channels,” Journal of Finance.

Miran, S (2024), A user’s guide to restructuring the global trading system, Hudson Bay Capital, November.

Pettis, M (2024), “Which country should design U.S. industrial policy?”,  Carnegie Endowment.

Setser, B (2025), “China’s Massive Surplus is Everywhere (Yet The IMF Still Has Trouble Seeing It Clearly)”, Council on Foreign Relations.