What a ‘Get Tough with China’ Stance Would Really Look Like

Before every get-together with China, the US goes through some ritualized complaining (the value of its currency has been the recent big talking point), the Chinese do some sabre rattling of their own, and perilous little of substance happens, except that the Chinese continue to have an economy with a substantial current account surplus, which not only works to the detriment of its major trade partners, but at this scale contributes to financial instability. So in a perverse way, China’s ongoing trade surplus is everyone’s problem.

Martin Wolf of the Financial Times reminds us that this dynamic shows no sign of self-correcting:

…both sides [China and the West0 have made mistakes in managing their economic interaction.

China, for example, allowed an extraordinary surge in exports and the current account surplus to mask the development of an increasingly unbalanced domestic economy. Chinese household consumption collapsed from an already very low share of 46 per cent of gross domestic product in 2000 to a mere 35 per cent in 2008.

These were foolish investments, made as a result of foolish policies. It is absurd for China’s leaders to complain about China’s consequent (and entirely unnecessary) vulnerability to US fiscal and monetary policies.

Meanwhile, the US and a number of other western countries allowed the supply of cheap foreign savings, partly from China, to encourage a huge surge in household debt, private consumption, residential construction and financial sector leverage. While the excess savings of the emerging world were not the principal cause of the financial crisis, they were a contributory factor.

It is key to recognize that Chinese consumption has not risen relative to GDP, which is what needs to happen for the imbalances to moderate. And even though the grumbling between the US and China has focused on the exchange rate, there are other issues in play which get little commentary.

One of the frustrations in talking about China is that it is not well recognized (at least in the MSM) how mercantilist its policies are. Many people in the US have come to accept the idea that China’s cheaper labor costs trump all, hence the US goose is cooked as far as manufacturing is concerned.

The problem is that for most products, that’s urban legend. Direct factory labor is ~10% for a whole raft of goods. For manufacturing moved to China, where the US is a substantial part of the end market, you typically see meaningful offsets to the labor cost savings: increased managerial/coordination costs (particularly if the work is outsourced rather than merely “offshored”), increased shipping costs, increased financing costs (due to longer supply chains). And you also have an increase in risks, which amounts to a hidden cost. Longer lead times makes it harder for the producer to respond to changes in demand and competitor moves. So the cost of being stuck with output that needs to be written down or off will also offset any labor cost savings.

And that’s before you get to strategic risk. Too often, Chinese subcontractors have gotten their know-how from their customers and have gone in direct competition. Even market leaders with world-class technology have lost out. As the New York Times reports:

Nearly all the components that Gamesa assembles into million-dollar turbines here, for example, are made by local suppliers — companies Gamesa trained to meet onerous local content requirements. And these same suppliers undermine Gamesa by selling parts to its Chinese competitors — wind turbine makers that barely existed in 2005, when Gamesa controlled more than a third of the Chinese market.

But in the five years since, the upstarts have grabbed more than 85 percent of the wind turbine market, aided by low-interest loans and cheap land from the government, as well as preferential contracts from the state-owned power companies that are the main buyers of the equipment. Gamesa’s market share now is only 3 percent.

With their government-bestowed blessings, Chinese companies have flourished and now control almost half of the $45 billion global market for wind turbines. The biggest of those players are now taking aim at foreign markets, particularly the United States, where General Electric has long been the leader.

The story of Gamesa in China follows an industrial arc traced in other businesses, like desktop computers and solar panels. Chinese companies acquire the latest Western technology by various means and then take advantage of government policies to become the world’s dominant, low-cost suppliers….

Companies like Gamesa have been so eager to enter the Chinese market that they not only bow to Beijing’s dictates but have declined to complain to their own governments, even when they see China violating international trade agreements.

If the US is to reduce its dependence on debt as a driver of growth, it needs to reduce its trade deficit. That in turns means adopting a savvier stance regarding trade.

Steve Pearlstein in the Washington Post (hat tip reader Michael Q) outlines what a more forceful negotiating posture might look like:

The right response to these challenges would be for the president this week to laud China for the success of its economic policies and announce that the administration will begin forthwith to apply each and every one of them to Chinese exports into the United States. Subsidies and directed credit for local companies, buy-American provisions for government agencies and government contractors, currency manipulation, the rules on “conditional market access” and “indigenous innovation” – surely China could hardly complain if we were to pay them the highest compliment by embracing their economic model.

To start things off, the administration might announce its intention to block the joint venture Hu intends to announce later this week with General Electric. GE already sells lots of engines to China for all those Boeing and Airbus jets it buys. Now GE is hoping to get the contract to provide avionics to the state-owned Commercial Aircraft Corp. of China, which intends to go into direct competition with Boeing. What better way than by forming a 50-50 joint venture with Aviation Industry Corp. of China, another state-owned firm?

In addition to $200 million, GE will be contributing technology to the partnership that will operate as the avionics brain for Boeing’s new 787 Dreamliner. And going forward, the partners will jointly develop new radars, controls and guidance system at a jointly run research and development laboratory that is already under construction. Call me cynical, but this sure sounds as if one of America’s leading technology companies has decided to sell some of this country’s crown jewels to ensure access to China’s rigged market, potentially jeopardizing the competitive advantage enjoyed by this country’s leading export industry.

This is the nub of the problem. With its state-controlled economy, China can force its companies to act collaboratively to achieve the country’s strategic economic objectives. And that gives it a tremendous advantage in negotiating the terms of trade with a country like ours, where China can strike deals that may provide short-term profits to one company and its shareholders but in the long run undermine the competitiveness of the other country’s economy. What’s good for GE or Honeywell or Rockwell is, in this case, almost certainly not good for America and American workers.

Pearlstein correctly points out that Americans are sqeemish about the idea of industrial policy. But we already have industrial policy of the worst sort, industrial policy by default.

The US and its trade partners have engaged in a 30 year experiment of deregulation, financial liberalization, more open trade, and deep integration of markets. But most other countries had clear objectives: they wanted to protect their labor markets, which usually entailed running a trade surplus (or at least not a deficit). Many of them also had clear industrial policies. By contrast, the US pretended it was adhering to a “free markets” dogma so that whatever resulted from this experiment was virtuous. But in fact, we have had stagnant real worker wages, with a rising standard of living coming from rising household borrowings and to a much lesser degree, falling technology prices. We have also had industrial policy by default. Certain favored groups, such as defense companies, Big Pharma, and the sugar lobby, get special breaks.

I don’t expect to see major changes any time soon, but trying to perpetuate a failing status quo is not a winning strategy.

Originally published at naked capitalism and reproduced here with permission.