Australia and Economic Cold War – Drifting into the New Paradigm

In her 2025 AIIA National Conference Address, Dr Heather Smith warned that without urgent economic reform, sovereign capability, and a fundamental shift in national mindset, Australia will lack the resilience and autonomy needed to navigate an era of major-power rivalry and weaponised interdependence.

To say that Australia is not well positioned for this world is an understatement. It’s lonelier and more fraught for us – as demonstrated by both our key strategic partner and our key economic partner having engaged in economic coercion against us.

The world Australia faces is increasingly undemocratic, grievance-driven, aggressively interventionist and multipolar.

Our fear of abandonment, as Allan Gyngell described so well, has never been more palpable.

Adam Posen describes it as the US having switched from global insurer to extractor of profit, having ripped up the post WWII insurance contract of underwriting global public goods. The most impacted are allies, like Australia, who bought into the system and were freed up to spend less on securing their future.[i]

Our desire for a strategic equilibrium in the Indo-Pacific would seem to no longer be achievable. Indeed, we are now in a state of strategic disequilibrium that will be the norm for some time.

Our bilateral policy framework of ‘stabilisation’ also seems precarious as Beijing undoubtedly will seek to test what it has called our ‘two-faced’ policy as we juggle our economic and strategic interests. We should be under no illusion that China will act in anything but its own interest and that it will be ruthless in doing so. At the same time, it is not in our economic interest, nor our region’s, that China’s economic rise be contained, even if it could be.

So, in this world of great power politics, can Australia maintain a degree of agency?

In my view, yes, but suggesting we can have complete strategic independence is an illusion. That said, we must come to terms on how to construct and use our agency to prepare for greater strategic autonomy.

However, our public and indeed private strategic discourse on the US remains narrow, binary and circular – focussed on the centrality of the alliance and AUKUS as our strategic saviour rather than framing it as a national endeavour with huge upside for industrial transformation of parts of our economy.

Little attention is given to understanding the longer-term implications for Australia of the internal dynamics of the US. As this audience knows well, conservatism and isolationism run deep in American history and the national psyche – from the ‘Know-Nothings’ anti-immigration party of the 1800s to the America First Committee of the 1940s.

We have seen a weaker version of US style anti-elitism playing out in Australia with the culture wars against our universities, migration, and diversity and inclusion. While this may be satisfying to some, it’s an indulgence that detracts from the efforts needed to respond to the external threats and position us for the future.

Respondents to public polling by the Lowy Institute reflects the contradictions of our national circumstances.[ii] Trust in the US has fallen dramatically and has been falling for the past 15 years. Yet a large majority of Australians still regard the alliance as central to our security and think the US will come to our defence if we are attacked.

Australians are cautious towards China and divided on our economic engagement, despite China having fuelled our growth and rising living standards over the last quarter of a century. Most think China could be a military threat in the next two decades, with half supporting an increase in defence spending, without identifying how it will be paid for.

More than half of the respondents assume China will be the most powerful country in a decade and lead technologically compared to the US. And most would prefer goods to be made in Australia even if it costs more, even though our services sector is 80 per cent of our GDP.

To exercise our agency, as a nation we need a mindset shift – to think differently about our interests and place in the world. A new global landscape is taking shape. Yet relative to Europe and others in our region, it is striking how slow we are in preparing for a new paradigm.

As I said, we need to be hedging by planning for greater strategic autonomy, as distinct from strategic independence.

Let me be clear, this does not mean turning away from the US. But it does mean inoculating ourselves by taking out a more comprehensive insurance policy than in the past, meaning more self-reliance, more defence spending and sovereign defence capability, and more hedging of our interests through new coalitions and partnerships, whilst continuing to support regional partnerships.

As I have said in this forum previously, what we do at home to build our resilience and competitiveness should be just as important as how we plan for the defence of our nation. We must get our economic house in order, and quickly. If we don’t, we significantly limit our strategic flexibility.

We are not without agency. Australia’s stable political system, Westminster system of government, our proximity to and enmeshment in the fastest growing region of the world, a sound financial sector and macroeconomic frameworks, including a flexible exchange rate, has enabled the economy over several decades to adjust to crises.

And we have been effective in leveraging our geography in our defence and intelligence relationship with the US, even though most Australians would not know this.

But for too long we have underinvested in the foundational elements of our nation that are required to better position us for a new world – whether it be sovereign science and technology capability, a diplomatic footprint that reflects our global interests, defence spending that reflects our strategic circumstances, an industry policy that enables future growth rather than protecting the past, a migration policy that truly focuses on bringing in the best and brightest, or a concerted rather than piecemeal strategy that positions us for sustained major power competition in the Indo-Pacific.

On this last point, despite the naysayers, the current Government deserves credit for its approach to date.

This aside, over the years we have been incremental and ad hoc in our approach to economic reform, too reliant on China to fund our rising incomes, and too sanguine about the security umbrella of the United States to protect us. Taken together we have become a complacent country, without a comprehensive insurance policy in the face of unprecedented global transformation.

We are yet to move the dial on productivity growth – our performance is now the second lowest in the OECD. This is not new – our productivity performance has declined consistently over the last few decades. The recently convened Economic Roundtable by the government clearly recognised this, but just how much political will exists for comprehensive reform remains to be seen.

Self-insuring will require greater sovereign capability. But getting the balance right on industry policy will not be easier given our history of protecting declining industries and our fragmented innovation system.

In the Intelligence Review, Richard [Maude] and I said structural changes were needed in the Australian bureaucracy to enable government to better balance multiple interdependent economic and national security objectives. This change was needed because of the inevitable fiscal and societal trade-offs we face in ensuring our economic and national security.

That is why we recommended Treasury play a broader and deeper role in advising on economic security decision-making that, pleasingly, the Government is pursuing. Treasury is the only agency that can bring broad and integrated economic perspectives and decision-making frameworks to ensure advice to government now, and into the future, encompasses all relevant national interests.

Because having multiple and loosely-defined goals – whether to create manufacturing jobs, build national capacity, promote national security, or accelerate the clean energy transition – will always be a difficult balancing act, but particularly so given our lack of scale and market power.

And as recent calls by some in the political class for a revival of Australian manufacturing show, the political economy concerns of industry policy interventions haven’t changed. This is despite the clear evidence of the past that sound macroeconomic policy along with a policy-driven incentive structure that can mobilise and align private sector capital with national priorities, is what really drives productivity and hence growth in living standards.

Yet, after decades we have yet to move the dial on some of the foundational elements of growth – R&D spending, where we still rank well below the OECD average, and private sector investment, that continues to be weak.

External partnerships like AUKUS Pillar II offer the potential to enhance our advanced technological capabilities but will take time to come to fruition and currently lacks alignment with other initiatives that would create sovereign scale and capability.

In our review, Richard and I also concluded that a bolder approach was needed in the form of the creation of a national security investment fund, along the lines of In-Q-Tel in the US and the National Security Strategic Investment Fund in the UK.

My point here is that we will have to move beyond rhetoric into action, and much faster than our political and bureaucratic decision making currently allows. Our lack of progress on ourmunitions and liquid fuel stocks is a case in point. And while the landmark agreement on rare earths between Australia and the US represents a political watershed in the bilateral relationship, as someone who was involved in the early stages of our critical mineral’s strategy, it has taken us, and the US, way too long to get to this point.

Perhaps nothing best illustrates our propensity to underinvest in our future than in our approach to our understanding of the Indo-Pacific. As recent research has shown, enrolments in Asian languages are at their lowest levels in decades. Our take up of second language learning is amongst the lowest in the developed world.[iii] We seem unconcerned that China studies in Australia have gone backwards, not helped by some who don’t seem to accept that furthering our understanding of China does not mean agreeing with its ideology, governance model or policies.

If we had pursued that approach in decades past with the Soviet Union, we might never have had George Kennan writing as `Mr X’ in Foreign Affairs in 1947. And without the knowledge of Kennan and others, the Cold War could have played out very differently.

Dr Heather Smith PSM FAIIA is the National President of the Australian Institute of International Affairs. This is an excerpt of her speech to the 17 November 2025 AIIA Gala Dinner. Full versions of conference speeches, including Dr Smith’s speech, are available here.

[i] Adam S. Posen, The New Economic Geography, Foreign Affairs, August 19, 2025.

[ii] Ryan Neelam, Lowy Institute Poll Report, June 6, 2025.

[iii] Philipp Ivanov, The Renewed Case for Asian Literacy, Asia-Pacific Development, Diplomacy and Defence Dialogue, 25 September 2025.

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