The Price of Resilience

This week marked a significant geopolitical moment, as Chinese President Xi Jinping made his first state visit to the United States since 2015. Admittedly, expectations weren’t high. Even as their trade, technological and military rivalry has deepened, the two powers have remained highly interdependent, in large part due to their integrated supply chains. This interdependence was built over several decades, particularly through the balance of payments External link., because it benefited both countries. Consequently, reducing that interdependence in pursuit of greater autonomy means sacrificing some of its benefits. This trade-off can be viewed as a form of insurance, where higher short-term costs are accepted in exchange for decreased vulnerability in the future. Although the long-term geopolitical trend is still moving toward reduced interdependence, both sides would prefer to spread the resulting costs over time.

Of course, the United States and China are just one example of a broader global dynamic. In a decade defined by the pandemic, the war in Ukraine, the trade war and intensifying supply shocks, governments and businesses have been reminded that maximizing economic efficiency cannot come at the expense of geopolitical resilience. Previously, the expansion of free trade and a more stable geopolitical landscape made it seem like this trade-off involved minimal risk, since pursuing lower costs and deeper economic integration didn’t appear to increase vulnerability.

The current debate about regulating artificial intelligence is another example of this dynamic. Imposing additional restrictions on the development of advanced AI models means paying some costs today—in the form of foregone benefits—to reduce the likelihood of serious consequences tomorrow. In this particular case, the trade-off is complicated by the fact that AI is also central to the geopolitical and technological competition between the United States and China. Efforts to reduce one risk may therefore heighten another if one of the rival powers presses ahead with the technological arms race.

More broadly, many countries are feeling the need to diversify supply chains, secure access to critical minerals, strengthen national defence capabilities and energy infrastructure, and reduce strategic dependencies. In the face of such daunting challenges, economies like the European Union, Japan, South Korea, Australia and Canada have adopted more interventionist approaches that prioritize their sovereignty.

These approaches have often been presented as investments rather than expenses. With public finances under strain, the word “investment” has a positive connotation because it suggests that expenses incurred today will ultimately generate dividends, either directly as income or indirectly as greater productive capacity. However, this more positive connotation means the word is now being used indiscriminately to justify a wide range of initiatives whose economics vary considerably and whose dividends are not always tangible.

In a world of relative stability and predictability, “investing” meant allocating capital to wherever it could earn the highest risk-adjusted return. But some of the investments being considered today are motivated by the need to navigate a more unstable and unpredictable global environment. Investing in domestic production may be justified if it reduces dependencies, even if this kind of production costs more. Similarly, a government seeking to build sovereign digital infrastructure, as Canada is currently proposing, can highlight the benefits of greater resilience and autonomy, even when a less expensive foreign solution already exists.

Investment in defence provides an even clearer example. The OECD estimates External link. that allocating one additional percentage point of GDP to defence would only raise GDP by around half a percentage point after five years. After all, the main benefits would be stronger defence capabilities and deterrence, whose value is measured based on a counterfactual, namely the adverse events they help prevent. This kind of investment does create capital, but not necessarily productive capital.

This is one of the defining features of investments in resilience. When calculating the return on these investments, the losses avoided count just as much as additional output in the traditional sense, and sometimes more. In this respect, investing in resilience is like an insurance policy.

That insurance obviously comes at a cost. And in some cases, the bill can be quite steep. As we noted this week in our Economic and Financial Outlook External link., current goals face serious resource constraints. Whether we’re talking defence, infrastructure, artificial intelligence, the energy transition or the reconfiguration of trade corridors, these goals will simultaneously require capital, electricity, materials, construction capacity and a skilled workforce at a time when the population is aging.

Why is this a particularly big challenge for Canada? Because the budgetary commitment required to achieve all these goals will likely be massive, even with private capital External link., while productivity growth remains anemic. Weak productivity growth has a direct impact on living standards and governments’ fiscal capacities. In a less threatening geopolitical environment, it would have been entirely reasonable to argue that all investment should be directed toward measures that could help improve productivity. But increasing productivity must now compete with improving geopolitical resilience, lowering the cost of living (by building more housing, for example), adapting to climate change and making basic infrastructure repairs and upgrades: all goals that draw on the same capital resources.

Admittedly, some investments meet multiple objectives. These include trade corridors to diversify trade, electrical grids and transmission systems, and certain dual-use defence technologies.

However, the direct economic benefits are more limited for investments such as redundant digital capacity that may remain unused. The challenge then becomes finding the right balance between strengthening resilience and increasing production capacity to ensure lasting economic prosperity.

In the worst-case scenario, interventions would be poorly calibrated or rolled out in the wrong sequence. A large number of projects with major cost overruns would be launched, and demand for capital would further increase the cost of financing (and the associated crowding-out effects), without generating enough additional revenue to ensure fiscal sustainability. Countries that fail to strike the right balance will pay the price in higher borrowing costs, capital flight and currency depreciation.