Trade: China Doesn’t Play by the Rules

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Readers may have taken note about the robust debate among Serious Economists about free trade, provoked in large measure by Harvard economist Dani Rodrik holding some of his peers’ feet to the fire (note that Rodrik is not anti-free trade, but anti sloppy or dumbed down justifications).

One continuing bone of contention between economists and the lay public is theory versus practice. The real world of free trade doesn’t hew very closely to the abstract models; the gains asserted (and estimated) for open trade seem hard to square with the loss of manufacturing jobs (and stagnant blue collar wages) and now the threat to white collar employment posed by offshoring.

A post today by Thomas Palley, “US – China Trade: Pay Now or Pay More Later,” helps explain some of the divergence. In a nutshell, the US cut what now appears to be a very poor deal with China, and is now (with considerable difficulty) trying to renegotiate it. The recent approval of countervailing duties on coated paper (a product that China was subsidizing heavily to undercut American producers, and one in which it has no natural advantages, since it is capital intensive and all the machines are purchased overseas) is a first shot across China’s bow.

One test will be how Hank Paulson’s visit to China to press for more open trade in services (read financial services) goes. Given China’s tone of late, we are not optimistic. And Palley isn’t either.

From Palley:

Today’s international trading system is a liberal order in which open exchange works well when all participants are market economies. However, it is widely recognized that individual countries can strategically game the system for their benefit at the expense of others. That is why the system needs rules and a spirit of cooperation. The problem is China has been admitted into the system but it is unwilling to play by the rules, in letter or spirit.

This unwillingness reflects political realities within China. China is strongly nationalist and prone to equate negotiation with external pressure. It remains an authoritarian country in which extensive state economic intervention is normal, and it is also beset by political divisions between hard and soft-liners that limit its ability to deliver on its WTO commitments.

In retrospect the US decision in 2000 to permanently open its markets to China seems poorly conceived. That decision was driven by manic optimism about globalization that pushed a biased benefit – cost calculus that ignored economic and political reality. The Clinton Administration naively argued that simply exposing China to market forces would transform it into a democratic ally, while US multinationals lobbied heavily on China’s behalf seeing it as a profitable offshore production location.

The net result is the US is now stuck between a rock and a hard place. Either it must live with China’s gaming of the system that slowly erodes US economic foundations, or it must adopt a tougher policy stance that even risks a costly trade war.

The downside of tougher policy is a trade war, which could be very disruptive. The upside is that it could spur a speedy negotiated settlement. Chinese policymakers are realists and likely recognize that China has more to lose from a trade war because it needs access to US markets for its manufacturing sector and to attract foreign direct investment. Moreover, China is vulnerable to losses on its large holdings of US financial assets.

Even if a trade war cannot be avoided, the US still stands to benefit from tough policy because it is better to fix the problem now rather than later. Delay is costly. Larger trade deficits mean greater dependence on Chinese imports, along with further erosion of the US manufacturing sector’s ability to replace those imports. Had the US acted firmly five years ago, the costs would have been smaller and manufacturing healthier. Another five-year delay means further erosion of manufacturing and larger costs to any future trade war.

Inevitably, the new tougher stance has triggered accusations that the US is engaging in protectionism. These accusations are based on faulty economics and fail to distinguish protectionism from legitimate economic self-defense.

Opponents claim that the trade deficit stems from lack of US saving, not exchange rates. This argument misunderstands market economics. Reducing the trade deficit requires increasing exports and decreasing imports. That requires inducing foreigners to buy more U.S. made goods, and inducing Americans to “switch” their spending from imports to domestic made goods. Market economies accomplish this through changed relative prices. That calls for exchange rate adjustment that makes foreign goods more expensive for US consumers, and US goods cheaper for foreign consumers.

The opposition to tough policy also comes wrapped in faulty economic history that blames protectionism and the Smoot-Hawley tariff for the Great Depression. Yet, the fact is Smoot-Hawley was passed in June 1930, after the Depression had already begun. Moreover, its economic effects were minor given the pre-existing high US tariff structure of 34 percent and small US engagement in trade (less than ten percent of GDP).

The reality is that the US has delayed addressing the China trade imbalance problem for five years. That delay has harmed manufacturing, distorted the current economic expansion, and raised the costs of remedy. Further delay will do further injury and further raise the costs of future remedy. That is the inexorable logic of “pay now or pay more later”.

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