The Politics and Economics of the U.S.-China Trade War

Deborah L. Swenson University of California, Davis Department of Economics 1122 SSH Davis, CA 95616 [email protected] Wing Thye Woo University of California, Davis Chinese Academy of Social Sciences, Beijing Sunway University, Kuala Lumpur Fudan University, Shanghai [email protected]

Abstract The United States declared trade war after substantial defections from the internationalist (in geo- strategy and economics) lobby in U.S. politics to a new coalition between conflict-is-inevitable activists and anti-globalization proponents. Many internationalist businesses changed sides after experiencing disappointments on economic fronts including China’s non-compliance with some of its World Trade Organization (WTO) obligations, China’s acquisition of foreign technology at lower-than-expected prices, and the serious inadequacies in the WTO’s governance of global trade. Many of the disillusioned internationalists have given too much weight to the contribution of globalization to negative developments in the U.S. labor market, and too little weight to the role of powerful capital-biased technological changes and to the inadequacies of state-provided programs for social insurance and human capital formation. Resolution of the trade war and prevention of its frequent occurrence will become more likely when (a) China adopts much greater reciprocity in its economic engagement with the advanced countries despite its status as a developing country under WTO rules; and (b) the United States stops equating geo-strategic competition with economic competition, recognizes that economic dynamism and economic resilience comes from strengthening indigenous innovation capability rather than from holding China back technologically,and institutes social programs to significantly reduce the trauma that is created by frequent job changes. Deep reform of the WTO is urgently needed but is unlikely to hap- pen in the medium run. For the medium run, the United States should mobilize country cooperation in regional settings (like the Trans-Pacific Partnership [TPP]) to introduce policy innovations to serve as templates for a re-designed WTO architecture, and to harness collective market power to be used in future negotiations on WTO reform.

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1. Introduction

After over 16 months of intense negotiations, marked by occasional drama but always lightened by late night tweets from Donald Trump,1 the United States and China agreed to a limited trade deal on 11 October 2019 that amounted to a truce in their trade war. The Americans put off a scheduled tariff increase on US$ 250 billion of Chinese imports, and the Chinese agreed to buy US$ 40 to 50 billion worth of U.S. agricultural products, be more transparent in foreign market interventions, ease U.S. entry into the ﬁnancial services sector, and enhance enforcement of intellectual property rights. Trump called this truce “a substantial phase one deal” even though speciﬁc details were not released, and nothing was signed.2

The U.S.–China trade war is only one part of Trump’s stated ambition to radically alter U.S. foreign economic relations. Just days after his inauguration in February 2017, Trump with- drew the United States from the TPP. Other early moves included the imposition of tariffs on steel and aluminum imports, and demands that Mexico, Canada, and Korea renegotiate the North American Free Trade Agreement and the Korea–U.S. Free Trade Agreement.

On 22 March 2018, the United States Trade Representative (USTR 2018) released a report on China’s practices related to technology transfer, intellectual property, and innovation that accused China of unfair trade practices, and Trump announced that he would be imposing tariffs on Chinese imports. A series of China-speciﬁc tariffs were imposed beginning on 6 July 2018, and China retaliated in tit-for-tat fashion. By the time of the truce in October 2019, the United States had active tariffs on about US$ 375 billion of Chinese goods, and China had active tariffs on US$ 110 billion of U.S. merchandise exports.3

1 Noteworthy acts by the United States’ side included embarrassing Vice-Premier Liu He “on ﬁve different occasions by discarding understandings he thought had been reached or announcing measures on the eve of trade negotiations” (Mitchell, Tom. 2019. China makes few concessions in trade truce with U.S. Financial Times. Available at: https://www.ft.com/content/6a30ed00 -ecd1-11e9-ad1e-4367d8281195); the reduction in academic exchange; and Trump’s tweets that China badly needed the trade war to stop soon. Key acts from China’s side included the “unex- pected” rejection in May 2019 of a draft agreement that, according to the Americans, had been reached smoothly (Lo, Kinling. 2019. What killed U.S.-China trade talks: A tale of two texts. South China Morning Post. Available at: https://www.scmp.com/news/china/diplomacy/article /3010456/what-killed-us-china-trade-talks-tale-two-texts); depreciation of the RMB–US$ rate to beyond 7; an announced total ban on U.S. agricultural products; and the abrupt departure of Chinese negotiators from Washington, DC, in September 2019. 2 Apparently, the details would be worked out by 15 November 2019 when Donald Trump meets with Xi Jinping at the Asia-Paciﬁc Economic Cooperation meeting in Chile. 3 These two numbers are from Timmons and Lawder (2019), which differ from US$ 550 billion and US$ 185 billion (respectively) in Wong and Koty (2019). The Wong and Koty numbers include scheduled tariffs that were announced but not implemented by 11 October 2019. For reference, in 2017, U.S. imports of goods from China were roughly US$ 505 bn, and U.S. exports of goods to China were about US$ 130 bn.

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Our analysis of the U.S.–China trade war is organized as follows. Section 2 identiﬁes the different U.S. interest groups on China trade, and Section 3 explains why U.S. trade policy has pivoted away from its traditional emphasis on trade liberalization and global integration. The next four sections, Sections 4 through 7, focus on four economic factors that generated immense political pressure for U.S. protectionism: negative outcomes in the U.S. labor market, China’s violations of WTO norms, U.S. worries about China’s technology acquisition practices, and serious defects of the WTO system. Section 8 analyzes the economic consequences of the trade conﬂict on the United States and the world, and Section 9 proposes policy adjustments for the United States and China to resolve their trade war and forestall its frequent reoccurrence.

2. U.S.perspectives on economic engagement with China

Policy choices are nearly always the end-products of two contests: the contest of ideas and the contest of interest groups. These two contests are often linked because each interest group naturally pushes for the set of worldviews and solutions from which they will bene- ﬁt. For most important economic issues that affect many U.S. groups (e.g., U.S.–China economic relations and U.S.–Saudi economic relations), no single U.S. interest group is likely to be strong enough on its own to determine the U.S. policy position. As a result, when a coalition of interest groups brokers compromises among themselves, their formation of a majority coalition on their issue of interest generally enables them to steer the setting of the national policy position on that issue.

Our point is that significant change in policy regarding important economic matters, in most cases, is the outcome of the emergence of a new majority coalition on that issue. The reason why the U.S.–China trade war started in 2018 when the U.S. merchandise trade deficit was under 4 percent of GDP—rather than in 2006 when U.S. merchandise trade deficit was over 6 percent—is that the majority coalition on China trade in 2006 was no longer the majority coalition in 2018. Clearly, other factors aside from the trade imbalance have played a larger role in the transformation of the majority coalition. To identify these factors of influence, we looked at the range of U.S. opinions on China trade, which can be classified into four lobby groups.

Lobby Group 1 consists of geo-strategists who advocate preserving the primacy of the United States in the global system.4 They are strident supporters of protectionism against China because they believe that the logic of geo-strategic competition makes the U.S.– China conﬂict inevitable (e.g., Mearscheimer 2001). Members of this group believe that

4 Blackwill and Campbell (2016, 29–36) want “to avoid a U.S.-China confrontation” but they want to “maintain U.S. primacy in Asia. . . . [Hence an] energized American pivot to Asia is the indispens- able ingredient in a successful U.S. policy to participate and project strength more consequentially in the region and to deal with Chinese power and inﬂuence under Xi Jinping.”

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postponement of the conflict will make the final conflict costlier and the final outcome less certain for the United States because the extra time will allow China to reduce the technological gap, and to strengthen the coalition of authoritarian regimes opposed to the United States. This thinking has motivated anti-Communists like former White House advisor Steve Bannon to push for the quick containment of China through economic decoupling and technological decoupling. Lobby Group 1 is the Security-first lobby, with many of its members also espousing the America-first mentality.

Lobby Group 2, which is largely aligned with labor unions, draws its membership particularly from import-competing industries. Though cheap Chinese imports beneﬁt all consumers, including U.S. workers, Chinese imports have also threatened job loss for manufacturing workers in this group. Given limited social insurance programs and ineffective re-training schemes provided by the U.S. government, job loss—whether from technological innovations or from import penetration—imposes high social and economic costs on U.S. workers (Woo 2008). The proclivity for worker solidarity, the near-stagnancy of take- home pay for workers for over two decades, the greater frequency in job changes, and the positive correlation between globalization and income inequality have increased the desire for economic stability by Lobby Group 2 and rendered it receptive to trade protectionism. Lobby Group 2 is the Stability-ﬁrst lobby.

Lobby Group 3 consists of big business, high finance, and high-tech firms. Until about 2010, Lobby Group 3 was the strongest group in support of keeping U.S.–China trade relations amicable. Multinational corporations recognize that profit is maximized when market size grows, and each stage of production is outsourced to the lowest-cost country. After the United States and China completed the bilateral negotiations for China’s WTO accession in November 1999 (thereby guaranteeing access to U.S. markets by China’s exports), many U.S. manufacturers increased their profits by investing in China and servicing their U.S. customers from there.

Big U.S. and European financial firms recognized early on that China’s state-controlled (hence, also state-influenced) near-monopoly financial industry is incompatible with the financing needs of an economy experiencing rapid catching-up growth of over 9 percent a year. Even though China would extend national treatment to foreign financial firms only after five years of WTO membership (i.e., in 2006), big U.S. financial companies were confident that the competitiveness of China’s financial institutions would not develop sufficiently to present a competitive threat. Wall Street and other foreign banks saw the 2001–06 interval as the time to build up relationships with China’s businesses for future transactions.

Similarly, even though many big U.S. high-tech companies also faced severe restrictions in their China operations (e.g., Google and Facebook), they were optimistic for a long time

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that their technological superiority would eventually secure their entry into China. Lobby Group 3 is the Prosperity-ﬁrst lobby.

Lobby Group 4 consists primarily of geo-strategists who believe that, under normal cir- cumstances, the United States does not have the ability to mobilize enough international support to block China’s rise to global power. Further, these geo-strategists also believe that it is in China’s interest to partner with the United States as a means of forming an im- plicit Group of 2 (G2) to jointly shape the form of global governance (Kissinger 2011). These considerations led Robert Zoellick to invite China in 2005 to become “a responsible stakeholder” in the hitherto U.S.-designed international system. Until roughly 2011 (prior to Secretary of State Hillary Clinton’s Pivot to Asia), these internationalist geo-strategists were strong supporters of further economic engagement with China. Lobby Group 4 is the Partnership-ﬁrst lobby.

From the Carter administration through the Clinton presidency, the majority coalition on China policy consisted of the Prosperity-first lobby and the Partnership-first lobby (Lobby Groups 3 and 4). This pro-engagement majority coalition enabled the U.S. government to support China’s integration into the world economy (hence, the successful bilateral negoti- ation in November 1999 of China’s accession to WTO membership), and China’s inclusion into the governance of international organizations. The immense goodwill toward China in the period up to 2000 is exemplified by President Clinton’s hailing of China as a strategic partner of the United States.

3. The emergence of a new majority coalition on China trade

The immense growth of China’s economy has given it the resources to project force abroad to safeguard its borders and sea lanes on which its prosperity rests, to extend generous aid to friendly nations, and to enthusiastically boost research in science and technology. However, the signiﬁcant military expansion, the enhanced diplomatic outreach, and the quantum leap in technological prowess are also open to other interpretations as well, especially after the United States encountered several disappointments with China on the national security and the economic fronts.

The ﬁrst example of U.S. disappointment on the geo-strategic front is China’s mainte- nance of, and occasional increase in, support for some sworn enemies of the United States (e.g., North Korea and Iran) who have stepped up their incursions against U.S. allies (e.g., Japan and Saudi Arabia). The second example is China’s growing assertiveness in control- ling disputed air space and disputed islands in the East China Sea and South China Sea.5

5 Bosack, Michael MacArthur. 2019. China’s Senkaku Islands ambition. Japan Times, 12 June 2019. Available at: https://www.japantimes.co.jp/opinion/2019/06/12/commentary/japan -commentary/chinas-senkaku-islands-ambition/#.XbItIS3MzLY.

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Provocatively, China has built artiﬁcial islands in the South China Sea and located military assets there and has warned other nations not to trespass into the disputed areas.

Finally, the United States was greatly surprised by the growing effectiveness of the Chi- nese military in cyber-espionage (e.g., Unit 61398 of the People’s Liberation Army was able to scoop up the security clearance files of 22 million Americans) and the degree to which it was directed at U.S. commercial companies.6 The costly consequences for both countries from the escalation of cyber warfare between the two militaries were mitigated when President Obama and President Xi signed an agreement in 2015 to end China’s “yearslong practice of breaking into the computer systems of American companies, military contrac- tors and government agencies to obtain designs, technology and corporate secrets, usually on behalf of China’s state-owned firms.”7 Nonetheless, apparently, by November 2018, China’s military-backed cyber-espionage of U.S. military and U.S. commercial firms had resumed with a vengeance.

The military is an instrument that is normally reserved for use in geo-strategic competition, and China’s use of it in economic competition (spying on commercial enterprises) rightly set off warning bells in the U.S. national security services and American society about whether the Chinese government sees the United States as an active enemy and had launched a stealth campaign “to replace America as the Global Superpower” (Pillsbury 2015).

Disappointments, like these three examples on the geo-strategic front, have rendered the Partnership-first geo-strategists (Lobby Group 4) vulnerable to the accusation by Security- first geo-strategists (Lobby Group 1) of being guilty of the naïve belief “that engagement will lead to a more open, liberal China; that the Communist Party does not have expansion- ary ambitions; and that communist ideology no longer matters.”8 Together, China’s actions and the criticisms of Lobby Group 1 have caused many internationalist geo-strategists to become skeptical about China’s commitment to playing a constructive role in the existing global system, resulting in some moving into the Security-first camp (Lobby Group 1), and

6 Chin, Josh. 2015. Cyber Sleuths Track Hacker to China’s Military. Wall Street Journal. Available at: https://www.wsj.com/articles/cyber-sleuths-track-hacker-to-chinas-military-1443042030. 7 Sanger, David and Steven Lee Myers. 2018. After a Hiatus, China Accelerates Cyberspying Efforts to Obtain U.S. Technology. New York Times. Available at: https://www.nytimes.com/2018/11 /29/us/politics/china-trump-cyberespionage.html This article, however, did not mention what the U.S. military—being proﬁcient in cyber-espionage as well (Snowden 2019)—had committed to stop doing on its side. 8 Magnier, Mark. 2019. U.S. diplomat David Stilwell says Washington must shed its myths about China to check Beijing’s growing inﬂuence. South China Morning Post. Available at: https://www.scmp.com/print/news/china/diplomacy/article/3033461/us-diplomat-david -stilwell-says-washington-must-shed-its-myths.

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most of the remaining members of Lobby Group 4 muting their support for comprehensive cooperation to induce China to enter into a G2-type of arrangement for global dominance.

This realignment of strategy and membership within Lobby Group 4 during the George W. Bush and Barack Obama administrations also occurred within Lobby Group 3 (the Prosperity-first lobby). This parallel development took place because big business, high finance, and high-tech firms in the United States and other advanced economies encountered four major disappointments on the economic front. We will outline these four disappointments in this section, and detail some of them in later sections.

The first disappointment is that China has kept postponing the opening of many of its key markets despite its promise in November 1999 to do so. The second disappointment comes from the feeling of many foreign manufacturers that China is using its market power un- fairly to acquire their technologies at a discounted price via the Joint Venture (JV) require- ment where the products of these foreign firms could be sold in China only if the goods were produced within China in partnership with a Chinese firm (which would inevitably learn the production technology, and sometimes even improve upon it).9

The third disappointment is that China is making liberal use of its developing country status under WTO rules to deploy a wide range of subsidies and import obstacles to support the survival of inefficient state-owned companies (“zombie firms”) producing import- competing goods, and to boost the emergence of high-tech firms (as in the “Made in China 2025 Program”) that—contrary to the experience in most developing economies—would actually mature into internationally competitive suppliers of high value-added products.10

The fourth disappointment (or rather, the biggest area of surprise) is that China has proved to be extremely capable of winning key technology races. Huawei now leads the world in 5G technology, and, given the high level of funding for, and great speed of progress in, China’s space programs, China could soon be the global leader in space exploration.

These four disappointments on the economic front during the Bush and Obama administrations led many Prosperity-ﬁrst (Lobby Group 3) lobby members to reduce their advo- cacy for continued expansion of the economic relationship with China. It also caused some members to realign themselves with the Stability-ﬁrst lobby (Lobby Group 2). By the time

9 Sankei Shimbun. 2017. Japan’s Transfer of Bullet Train Technology A Mistake. China, Of Course, Has Copied It. Japan Forward Web site (accessed 25 October 2019). Available at: https://japan -forward.com/japans-transfer-of-bullet-train-technology-a-mistake-china-of-course-has -copied-it/. 10 Today, WhatsApp, which had its services impaired in China, faces a formidable challenger in WeChat.

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of Trump’s victory in the 2016 presidential election, the majority coalition on the issue of China trade comprised the enlarged memberships of Lobby Groups 1 and 2. This new majority coalition was fully prepared to take a more skeptical approach toward free trade, in general, and a harsher approach toward China, in particular.

It was, therefore, natural that one of Trump’s ﬁrst major appointments was Peter Navarro (presumably, along with his muse, Ron Vara11)—co-author of Death by China12—as a Deputy Assistant to the President, and Director of the newly created White House National Trade Council.13 The U.S.–China trade war was on.

4. Globalization (especially,the China Shock) and U.S.labor market outcomes

We now focus on four key economic issues that helped swing the mood of U.S. society toward protectionism, beginning with the alleged relationship between globalization and negative U.S. labor market developments. As in other major industrialized countries, the decline in U.S. manufacturing employment has been of great concern because of the perception that manufacturing provides “good jobs.” Figure 1 reports the number of manufacturing employees in the 1947–2019 period. Manufacturing employment rose by 4.5 million in 1960–79, fell by 1.5 million in 1979–2000, and fell by an additional 3.4 million from 2000 to mid 2007, before the global ﬁnancial crisis (GFC) began in September 2008. Was the decline in 1979–2000 caused by globalization, and the precipitous decline in 2000–07 caused by the acceleration of globalization induced by the entry of China into the WTO?

It turns out that it is hard to establish that globalization was responsible for most of the loss in manufacturing jobs. Figure 2 shows that the proportion of the U.S. labor force employed in the manufacturing sector has been falling secularly since 1947, long before globalization could be implicated. How should we interpret this secularly declining trend in manufacturing share of employment in the 1947–79 period before the total number of manufacturing jobs started declining in 1980? One reasonable null hypothesis is that technological innovations have reduced steadily the amount of labor required for production in the 1947–80 period.

11 Bartlett, Tom, 2019. Trump’s ‘China Muse’ Has an Imaginary Friend. Chronicle of Higher Educa- tion. Available at: www.chronicle.com/interactives/20191015-navarro?key=mi0Bff1vaLHL09 _no2Emg3BNpV0dUW8oz4uPCYaaJHO3I3RVhzs_l4nI4k1KBr7xdzJFUjVCUmhtT2ZXTk9 odmZORFdDaEh2VzJhV1ZVcjVGMUI2TEI4cXVIOA&te=1&nl=california-today&emc=edit _ca_20191016?campaign_id=49&instance_id=13113&segment_id=17931&user_id=9fd5e6293 aa05b8061395dda47b662a7®i_id=56580616. 12 Navarro and Autry (2011). 13 By October 2019, the White House National Trade Council had been folded into a new Ofﬁce of Trade and Manufacturing Policy with Navarro (having been promoted to Assistant to the Presi- dent) as its head.

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Figure 1. U.S. manufacturing employment (thousands of workers), Jan 1947–Sep 2019

Source: Bureau of Labor Statistics (series CES3000000001).

Figure 2. Percent of employment in manufacturing in the United States, 1947–2015

Source: Adapted from Chien (2015).

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The annual rate of decline in the manufacturing share of jobs was 0.37 percentage point in 1960–79, 0.38 percentage point in 1979–2000, and 0.43 percentage point in 2000–07. Under our null hypothesis, the underlying trend of job loss in manufacturing due to technological innovations is 0.37 percentage point per year in the 1960–79 period, and “normal” globalization added 0.01 percentage point annually to the underlying trend in manufacturing job loss in 1979–2000, and the “China WTO factor” added another 0.05 percentage point to that trend in 2000–07. The important point here is that the impacts of these two external shocks on manufacturing share of employment are miniscule compared with the impacts resulting from technological innovation, which reduces the share of manufacturing employment by 0.37 percentage point annually.14

The link between trade and manufacturing job loss has received recent attention due to the “China Shock” literature introduced by Autor, Dorn, and Hanson (2013) and extended by others including Acemoglu et al. (2016). This literature links relative declines in manufacturing employment, labor force participation, wages, and transfer payments at the local level to intensiﬁed competition in the local area’s base industries due to the rapid increase in exposure to Chinese exports in the early 2000s.

Based on the decline in the number of manufacturing workers and the decline in the manufacturing share of the labor force, it would be natural to assume that U.S. manufacturing output must also be in steep decline. The exact opposite is true, however. As Figure 3 shows, manufacturing output has experienced robust and continuing growth since the late 1980s, with the exception of the years immediately following the GFC. Furthermore, Figure 4 documents that the share of manufacturing value-added in GDP (both items measured in constant prices15), has been fairly constant in 1947–2015, with almost identical values (12 percent) in 1960, 1979, 2000, and 2015. Together, the negative correlation between manufacturing employment (Figure 1) and manufacturing output (Figure 3) and the absence of a correlation between the employment share of manufacturing (Figure 2) and the GDP share of manufacturing (Figure 4) suggest that the underlying declines in manufacturing employment are more heavily inﬂuenced by the adoption of new technologies and/or the increased utilization of capital rather than the fault of growth in trade.16 Put differently, the null hypothesis of technological innovation that we advance to explain the secular

14 If we accept Woo’s (2008) identiﬁcation of the beginning globalization being 1990 instead of 1980, which we had picked on basis of Figure 1, the impacts of the two external factors would still be minor compared with 0.37. 15 Because the price of manufactured goods rises less than the GDP deﬂator, the ratio of manufactured output to GDP will decline when both items are measured in current prices. This point is noted in Chien (2015). 16 If the underlying technological change the United States is capital-biased in nature, then there is also an underlying trend toward greater income inequality in the United States, with the top 1 percent obtaining an increasing share of national wealth.

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Figure 3. Manufacturing sector output in the United States (Index: 2012 = 100), 1987–2017

Source: Federal Reserve Bank of St. Louis (series MPU9900512).

Figure 4. Manufacturing as a share of gross domestic product (%), both items measured in constant dollars, 1947–2015.

Source: Adapted from Chien (2015).

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downward trend in Figure 2 can also account for the data patterns we provide in Figures 1, 3, and 4.

More recent research on the China shock shows that the problems in the U.S. manufacturing sector may not be due to trade. For example, when Feenstra, Ma, and Xu (2017) view the impact of U.S. trade developments between 1991 and 2011, they observe that the net employment impacts are almost balanced at the commuting zone level. Similarly, Feenstra and Sasahara (2018, 1503) note: “Comparing the growth of U.S. merchandise exports to merchandise imports from all countries, we ﬁnd a fall in net labor demand due to trade, but comparing the growth of total U.S. exports to total imports from all countries, then there is a rise in net labor demand because of the growth in service exports.”

Eriksson et al. (2019) speculate that the dislocation was more greatly felt in the case of the “China Shock” since the affected areas were at the end of their product cycle. The inevitable loss of some manufacturing sectors might have been easier to cope with if the ﬁrms had the leisure to innovate themselves into a new product space, rather than being forced out quickly. Together, these papers suggest that technology change, rather than interna- tionalization and the reduction in trade barriers, may be the proximate cause for declines in manufacturing employment in the United States and other industrialized nations.

The most important consequence of the perceived “China Shock” may be its effect on political polarization. On this dimension, Autor et al. (2017) interpret their results, connecting trade exposure with voting patterns, as “supporting a political economy literature that connects adverse economic conditions to support for nativist or extreme politicians.” Chal- lenges with China also appear to be fueling a fall in U.S. favorable opinions of China. For example, between 2005 and 2011, Pew Research polling revealed that U.S. favorable opinion of China surpassed the unfavorable share in all years but one, and the difference in that year was small. In contrast, since 2012, the share of U.S. unfavorable opinion of China has exceeded favorable opinion in all years.17

Woo (2008) suggests that globalization took a quantum leap upward in the period between January 1990 and February 1992 because of three developments. On 1 January 1990, the autarkic Soviet empire started unraveling when Poland became a market economy; at the end of 1991, India surprised many when it launched a sustained economic liberalization process in addition to implementing the standard macroeconomic adjustment programs as a response to its prosaic balance-of-payments crisis; and, in early 1992, Deng Xiaop- ing launched China’s move toward a socialist market economy with Chinese character- istics during his fabled Southern Tour. The point to note is that, until 1990, the absence of

17 https://www.pewresearch.org/global/2018/08/28/as-trade-tensions-rise-fewer-americans -see-china-favorably/.

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international integration involving these three almost-autarkic economies—Soviet-India- China (SIC) economies—held about one-half of the global labor force on the sideline, as they had minimal participation in the international division of labor.

Because the SIC economies were much poorer than the G7 economies, standard trade theory based on factor endowments predicts that their integration in the international economy would lead to a ﬂood of cheap imports into the United States—causing SIC wages to rise, U.S. unemployment to rise at least temporarily, and U.S. wages to fall. Nonetheless, the predicted outcomes for the United States did not occur. The average U.S. unemployment rate in 1990–2007 was lower than in 1973–90; and real labor compensation for U.S. blue-collar workers rose, albeit, sluggishly, in 1990–2007 (Woo 2008).

Standard trade theory predictions had failed because 1990–2000 was a period of heighted technological progress in the United States, and the higher income growth raised demand for labor and caused labor compensation to rise. The reason why higher labor compensation did not translate into higher take-home pay was that the increase in labor compensation took the form of higher medical beneﬁts due to large increases in the relative price of medical care.

It is not straightforward to argue that the sharp decline in manufacturing employment in the 2000–07 period had a substantial negative effect on the overall unemployment rate. Fig- ure 5 shows that the decline in manufacturing employment in 2001 and 2002 is associated with the unemployment rising from 4.0 percent in 1999–2000 (which was the lowest value since 1969) to 5.7 percent in 2001 and 6.0 percent in 2002, but then the continued decline in manufacturing employment is associated with a steady decline in the unemployment rate in 2003–06. If one were to claim on the basis of these two variables that the shrinking of manufacturing employment had raised the unemployment rate in 2001–02, then the same reasoning would require one to concede that the its subsequent decline in 2003–06 had somehow created many more jobs elsewhere to lower the unemployment rates in this later period!18 The more reasonable conclusion from Figure 5 is that the manufacturing employment decline had only temporary effects on the overall unemployment rate, and even then one cannot dismiss the possibility that most of the rise in unemployment rate in 2001–07

18 The labor force participation rate climbed from 66.4 percent in 1989 to peak at 67.2 percent in 1997– 98, and it was then 67 percent in 2000, 66.3 percent in 2002, 65.9 percent in 2004, and 66 percent in 2007 (see Figure 5). The maximum “discouraged worker” effect is given by [d(L/P)]/(L/P) where L = labor force size, P = population size, and [d(L/P)] = change in the labor participation rate. The “discouraged worker” effect—that lowered the ofﬁcial unemployment rate—equaled 0.004 percentage points in 2001, 0.006 in 2002 and 2003, zero for 2004, –0.002 in 2005 and 2006, and 0.006 in 2007. The size of the discouraged worker effect was not large enough to have overturned the reversals of the unemployment rate movement in 2002 and 2006.

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Figure 5. Manufacturing employment decline and labor market outcomes

Source: Bureau of Labor Statistics.

was due to the normal dynamics of the underlying unemployment rate cycle (which is a lagged indicator of the business cycle).19

Figure 6 suggests one more possible major economic reason for U.S. resentment toward imports from China prior to 2008, when the average U.S. worker was not experiencing increased unemployment or lower compensation. Figure 6 displays an indicator for male job security in each age group between 1951 and 2018. It reports the median number of years that male workers in each group were with their current employer. The median job tenure for males decreased as follows: (a) in the 35 to 44 age group it decreased from 7.3

19 One could assume that the unemployment rate cycle is symmetrical, and analyze the 1992–2007 component of the unemployment rate cycle with 1999–2000 as the trough by comparing the unemployment rates in 2001, 2002, 2003, 2004, 2005, 2006, and 2007 with those in 1998, 1997, 1996, 1995, 1994, 1993, and 1992, respectively, to assess the impact of the 2000–07 decline in manufacturing unemployment. These comparisons yield an unexplained rise in the unemployment rate in 2001–03 period and an unexplained fall in the unemployment rate in 2004–2007 (i.e., the results are contradictory if we look only at these two variables).

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Figure 6. Indicator of job security for males in age group (25–65 years), 1951–2018

Source: Adapted from Copeland (2019).

years in 1983 to 6.1 years in 1996, and then to 5.1 years in 2006; (b) in the 45 to 54 age group it decreased from 12.8 years in 1983 to 10.1 in 1996, and then to 8.1 years in 2006; and (c) in the 55 to 64 age group it decreased from 15.3 years in 1983 to 10.5 years in 1996, and then to 9.5 years in 2006.

The unambiguous message from Figure 6 is that job security for the U.S. workers after 1998 was signiﬁcantly and permanently lower than it was in the 1973–91 period. After 1998, globalization and technological innovation combined to require workers to change jobs more often, and workers experienced considerable costs associated with their job changes due to inadequacy of the U.S. social safety net (compared with the other G7 economies) and the ineffectiveness of U.S. job retraining programs.

5. China’s non-compliance with its WTO obligations

In advance of China’s WTO accession, the United States negotiated a bilateral agreement with China that provided explicit promises for four industries. We will discuss here the

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post-WTO experiences of two of these industries: the automobile industry and the electronic payments industry.

The bilateral agreement stipulated that China’s import tariff on assembled cars was to be reduced from its pre-WTO range (80 percent to 100 percent) to 25 percent by 2006 (with the largest cuts in the early years), and that the tariff on auto parts was to be lowered to an average of 10 percent by 2006. Hence, at the time of the 1999 agreement, foreign automakers expected the opportunity to produce automobiles in China using imported parts at the newly lowered tariff rates, absent any content regulations. China did begin to implement its promised tariff phase-in when it became a formal WTO member at the end of 2001, but, in 2004, China announced new rules that prevented many foreign assembly ﬁrms from utilizing the newly lowered tariffs on imported auto parts beginning in 2005.

Because China’s new automotive tariff regulations breached the terms of the original accession agreements, as well as common WTO obligations, the U.S., EU, and Canadian parties launched auto industry dispute cases against China at the WTO in 2006. Their cases noted that China’s new regulations compelled auto producers to purchase auto parts from domestic producers and also to transfer technology to China to enable it to become a major player in the automobile sector.

The WTO ruled against China 18 months later in 2008, requiring China to remove the of- fending tariffs. China immediately ﬁled an appeal against this ruling. Following the unsuc- cessful appeal of the WTO’s decision, China ﬁnally repealed its content-based auto import trade policy in September 2009.

Swenson (2012), however, found that China’s short-lived trade intervention in 2005–09 was enough to initiate extraordinary growth in China’s global export of auto parts because this short-lived policy had enduring effects on the global supply chains in the automobile industry. In the time interval that China’s protectionist policy was in force, many foreign parts suppliers relocated to China and created an efﬁcient auto parts industry in China. Though the United States technically won its WTO dispute settlement case, the time gained by China during the dispute process allowed Chinese-based ﬁrms to solid- ify their foothold as auto parts suppliers in the global market. In turn, the increased pres- ence of competitive parts suppliers in China increased the attractiveness of China-based auto assembly.

According to USTR (2019a, 78), U.S. concerns with the Chinese automotive market are continuing. USTR launched a new automotive dispute case in 2012 due to ongoing concerns that China was providing “numerous subsidies . . . to automobile and automobile parts exporting enterprises located in designated regions known as ‘export bases.’”

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The electronic payment services (EPS) industry is another one of the four industries that had explicit guarantees in the 1999 bilateral agreement of deadlines for their entry into China’s markets. As American financial firms had overwhelming strength in the provision of financial services, they anticipated great success in offering their products in China when China started implementing its WTO accession promises in 2006.

The subsequent failure of U.S. financial firms to enter China’s market in electronic payment services is representative of the disappointments that financial firms encountered across multiple financial products.20 For example, in response to China’s failure to open its EPS market in 2006, the United States launched WTO dispute case DS413 in 2010 to push China to meet its promise. WTO issued a favorable ruling to the United States in 2012, and China announced in 2013 its acceptance of the WTO decision. There was considerable delay in implementation, however. It was only in 2017, when China’s regulator, the People’s Bank of China, finally issued the final set of licensing rules that it would be enforcing.

However, USTR (2019a) notes that no foreign EPS supplier has yet obtained permission to enter China’s market even though the application procedures are now enumerated. Similar to the auto parts tariff case, the U.S. victory at the WTO win emerged only with a delay, and despite the favorable ruling, U.S. ﬁrms face ongoing challenges in entering China’s market.

6. Concerns about China’s technology policy

Because the proven way to increase economic prosperity is to increase productivity, it has been standard practice for a government to accelerate the acquisition of innovations from abroad and to strengthen the country’s indigenous capacity to innovate. China’s government is no exception.

A foreign firm that wishes to sell its products in China is sometimes told that its market access is conditional upon setting up production facilities in China in the form of a JV with a major government-linked company (who could later become a future competitor in markets outside of China). If it were Singapore instead of China that had presented this choice to the foreign firm, the foreign firm could well decide to forgo the small Singapore market. But because the Chinese market is large and because there are other competing foreign firms also seeking access to China’s market and possessing similar technology, a foreign firm is rendered more willing to trade its production technology for monopoly access to China’s market.

20 EPS manage and facilitate the movement of funds between ﬁnancial institutions that arise as customers use credit cards, debit cards, automatic teller machines, and other ﬁnancial transactions that involve the transmission of money.

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The outcome of this practice by China is effectively the equivalent of getting a lower price for the foreign technology in the long-term by using its market power. Is China’s exercise of market power really wrong when this is a case of “willing buyer and willing seller”? Feldstein (2018) has dismissed the “willing-buyer willing-seller” defense of this Chinese practice as disingenuous but we note that this case is no different from Walmart’s well- known practice of demanding and receiving big discounts from its suppliers, and there has been no wide public outcry against Walmart’s “disingenuousness.”21

U.S. firms have long complained quietly but bitterly to U.S. government officials about China’s use of its market power to pay an effectively lower price for technology.22 As mandated technology transfer contravenes WTO rules on market access, it is therefore a puzzle that it is only now that the U.S. government is willing to act against China’s “forced technology transfer” policy. The past reluctance to act could have been influenced by factors such as the absence of a coordination mechanism among the competing foreign firms to collectively reject China’s demand and to collectively request their governments to file WTO complaints; the perception by the U.S. government that the technology involved is not frontier technology that is critical for overall U.S. competitiveness and for U.S. national security; and the importance of China as an ally in international affairs (e.g., to vote for international action against Al-Qaeda after the September 2001 attack on the U.S. homeland, and to engage in joint macro-stimulus to counter the GFC ignited by the implosion of Wall Street in September 2008).

The recent turnaround in U.S. policy on mandated technology transfer is likely to have been due to a combination of developments such as the technology that China is now demanding is truly frontier technology that is necessary for the development of the next generation of high value-added products; the recognition that China is turning out to be more of a strategic competitor than a potential strategic partner; and the sense that China should not be treated like a developing economy because it has, after all, become the biggest aid donor in Africa and many parts of Asia and the global leader of 5G technology.

The U.S. concern about competition for global technological leadership has been inten- siﬁed by the ambitious goals espoused by China’s “Made in China 2025” (MIC25) policy announced in 2015. MIC25 calls for China to achieve a 40 percent revenue or global market share in the case of the advanced rail and maritime shipping industries, and for

21 One reason why Walmart’s suppliers have not united against Walmart’s use of market power is that U.S. competition laws forbid collusion by sellers to raise prices. There is, however, no international law to punish foreign ﬁrms for uniting to resist China’s JV demand, a point we will return to later. 22 Sullivan, Laura. 2019. As China Hacked, U.S. Businesses Turned A Blind Eye. All Things Consid- ered, National Public Radio Web site (accessed October 28, 2019). Available at: https://www.npr .org/2019/04/12/711779130/as-china-hacked-u-s-businesses-turned-a-blind-eye.

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Chinese ﬁrms to attain domestic market shares ranging from 70 to 95 percent in the automotive and robotics, new energy vehicles, power generation equipment, new materials, and agricultural equipment industries.23 To attain these objectives, China’s government plans to provide manufacturing subsidies, government purchase requirements, research and development and industrial funds, tax exemptions, and participation in the infrastructure programs of the Belt and Road Initiative.

Notably, the industries identified in the MIC25 initiative are at the technological forefront, which the United States and other industrialized countries also want to dominate. Further, because of China’s size, and the diversity of China’s manufacturing production capabili- ties, China’s high-tech firms have an advantageous foundation. Additionally, this concern about future Chinese competitiveness has been accentuated by fear in the United States and other advanced countries that the next generation of high technology could be appro- priated by Chinese firms through unfair means (e.g., Chinese firms being aided by cyber- espionage conducted by the Chinese military).24

7. Dissatisfactions with WTO’s governance of the world trade system

A natural start for dealing with Chinese practices that are viewed as “unfair” is to use the WTO dispute settlement mechanism. As discussed in a previous section, however,

23 Orlik, Tom. 2018. Who Has the Most to Lose If China’s Trade Ambition Succeeds? Bloomberg Newsweek. Available at: https://www.bloomberg.com/news/features/2018-10-30/who-has -the-most-to-lose-if-china-s-trade-ambition-succeeds. 24 It must be acknowledged that there has been “fake news” about Chinese cyber-spying. For example, Nix and Brody reported on Bloomberg that China had “sneaked spy chips onto servers used by U.S. companies including Amazon.com Inc” (Nix, Naomi and Ben Brody. 2018. China Spy Chips Report Adds Pressure on Pentagon Cloud Security. Bloomberg. Avail- able at: https://www.bloomberg.com/news/articles/2018-10-05/china-spy-chips-report-adds -pressure-on-pentagon-cloud-security), Apple, and Super Micro Computer Inc. All three companies have denied that they had found spy chips in China-made parts of their servers (Klein, Jodi Xu. 2018. Super Micro tells U.S. lawmakers it found no Chinese spy chips, deny- ing Bloomberg report. South China Morning Post. Available at: https://www.scmp.com/print /news/china/diplomacy/article/2170971/super-micro-tells-us-lawmakers-it-found-no -chinese-spy-chips) (Nicholson, Gareth. 2018. Amazon and Supermicro back Tim Cook and call for Bloomberg to withdraw China chip hack story. South China Morning Post. Available at: https://www.scmp.com/print/tech/article/2169758/amazon-and-super-micro-back-tim-cook -and-call-bloomberg-withdraw-china-chip). This misinformation occurred in October 2018 when the Pentagon was considering tenders from Amazon and Microsoft to build its US$ 10 billion cloud computing facility (codenamed Joint Enterprise Defense Infrastructure, JEDI). In Octo- ber 2019, the Pentagon awarded the contract to Microsoft when it was widely expected by technical experts and ﬁnancial analysts that Amazon would win the project because of its greater experience in this area (Gregg, Aaron, and Jay Greene. 2019. Pentagon awards controversial $10 billion cloud computing deal to Microsoft, spurning Amazon. Washington Post. Available at: https://www.washingtonpost.com/business/2019/10/25/pentagon-awards-...ntroversial -billion-cloud-computing-deal-microsoft-spurning-amazon/). Amazon is the pioneer of the cloud computing business and it had 48 percent of the business, whereas Microsoft had 15.5 percent.

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Table 1. The United States, European Union, and China as complainants in WTO disputes

Complainant WTO dispute cases against U.S. European Union China Argentina 5 8 Australia 4 1 Belgium 3 Brazil 4 5 Canada 8 6 Chile 1 3 China 23 9 — Colombia 1 Denmark 1 Egypt 1 European Union 20 — 5 France 4 Germany 2 Greece 2 1 Hungary 1 India 7 10 Indonesia 4 2 Ireland 3 Italy — 1 Japan 6 6 Korea, Republic of 6 4 Mexico 7 3 Netherlands 1 Pakistan 1 1 Philippines 4 1 Portugal 1 Romania 1 Russian Federation 1 4 Spain 2 Sweden 1 Thailand 1 Turkey 3 United Kingdom 3 United States — 35 15 Venezuela, Bolivarian Republic of 1

Source: https://www.wto.org/english/tratop_e/dispu_e/dispu_current_status_e.htm and https://www.wto.org/english/tratop_e/dispu_e/dispu_by_country_e.htm.

U.S. victories at the WTO court have often not translated into the desired increase in market access or market share in China. Furthermore, as WTO rulings also take too long to occur, there is widespread disillusionment with the adequacy of the WTO dispute settlement mechanism.

It is worth noting that the heaviest users of the dispute settlement system have been de- veloped countries including the United States and the EU, which have also been the most heavily targeted countries.25 Table 1 displays the number of WTO dispute cases that the United States, EU, and China have initiated, and the countries they have targeted. The

25 See WTO_Disputes by Respondent (https://www.wto.org/english/tratop_e/dispu_e/dispu _current_status_e.htm) and WTO_Disputes by Complainant (https://www.wto.org/english /tratop_e/dispu_e/dispu_by_country_e.htm).

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country frequency of dispute settlement cases launched by the United States are similar to those initiated by the EU, with the exception of China. While the United States has initiated 23 cases against China, the EU has launched only 9, and only a small number of other countries have launched dispute cases against China. The United States has naturally viewed other countries as free-riding on U.S. efforts to open China through WTO action. In addition, perhaps as a consequence of the more aggressive actions by the United States compared with other countries, the United States has been targeted by China in 15 dispute cases, whereas the EU has been targeted by China in only 5 dispute cases.

Reviewing the value of the dispute settlement mechanism for the United States, USTR (2019b) noted that successful use of dispute ﬁling has led to 34 cases where the interests of U.S. stakeholders was secured through “favorable resolutions or settlements that eliminate the foreign breach without having to resort to panel proceedings.”26 Schott and Jung27 have reported that nearly 40 percent of U.S. cases against China have been resolved quickly and without the need of a WTO dispute panel. Nonetheless, the frequency of cases in which the United States is named as a respondent in WTO dispute cases has caused the United States to view the dispute system as a nuisance.

USTR (2019b) has four other major complaints against the WTO. First, USTR accuses the WTO of not responding appropriately to trade distortions introduced by members that are non-market economies. Speciﬁcally, the WTO Appellate Body does not always recognize that a non-market economy like China is prone to creating excessive capacity in key products (like steel), which the non-market economy then seeks to solve by dumping its oversupplies on the world markets, creating adjustment hardships for market economies.

Second, USTR claims that the WTO dispute settlement does not fully respect Members’ sovereign policy choices. In particular, USTR sees the WTO Appellate Body as guilty of straying “extensively from original understandings” on trade regulations. Third, USTR wants the WTO to compel members like China to observe its “notiﬁcation obligations” fully in a timely fashion (e.g., to report details about industrial subsidies extended by local governments).

Fourth, USTR is opposed to the WTO practice of allowing countries to have the right to self-declare themselves as “developing economies” and hence can use tariffs and subsidies

26 Cases that had not met with successful resolution have proceeded to litigation. 27 Schott, Jeffrey J. and Euijin Jung. 2019. In U.S.-China Trade Disputes, the WTO Usually Sides with the United States. Peterson Institute for International Economics Web site. Available at: https://piie .com/blogs/trade-investment-policy-watch/us-china-trade-disputes-wto-usually-sides -united-states.

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to promote new industries. This is also the view of Pascal Lamy (former Director-General of the WTO), who called China—the world’s largest producer of desktop computers— “dishonest” to pretend that it is still “like India, or like Senegal, or like Botswana.”28

8. The effects of the U.S.–China trade war on the United States and the global economy

The direct effects of the U.S.–China trade war have been economically concentrated on a handful of U.S. sectors and regions. The first two rounds of the U.S. tariffs disproportion- ately affected U.S. firms engaged in U.S.-based manufacturing rather than U.S. consumers. Ninety-four percent of the tariffs levied in the first phase against US$ 50 billion in U.S. imports from China were placed on intermediate goods and capital goods. Similarly, 75 percent of the tariffs imposed by the United States in the second round on an additional US$ 200 billion of U.S. imports concentrated on intermediate and capital goods imports rather than consumer products (Bown, Jung, and Lu 2018). The increased production costs will ultimately raise consumer prices and reduce the competitiveness of U.S.-based producers.

The ironic contrast between Trump’s tariff decisions and the frequently expressed goal of returning manufacturing jobs to the United States is further intensified for U.S. exporting firms that are subject to China’s retaliatory tariffs. For example, U.S.-based automakers have experienced a dramatic decline in their exports to China as the U.S. tariff–induced production cost increases have been coupled with China’s retaliatory auto tariff of 40 percent.29 Rather than enhancing the competitiveness of U.S.-based car producers, the net effect of the U.S.–China trade war has brought the opposite effect. For companies such as German-owned BMW, the new tariff configuration increases the attractiveness relocating production to China as a new base to serve its Chinese customers.

Finally, although U.S. import tariffs on consumer goods and ﬁnal products may provide an incentive for ﬁrms to de-emphasize China as the source of their exports to the United States, this does not guarantee the return of jobs to the United States. Both relocation of existing foreign direct investment (FDI) in China (Donaubauer and Dreger 2018) and new FDI that might have gone to China would most probably involve countries such as Viet- nam or Mexico rather than the United States.

28 Bradsher, Keith and Alan Rappeport. 2018. The Trade Issue That Most Divides U.S. and China Isn’t Tariffs. New York Times 26 March 2018. Available at: https://www.nytimes.com/2018/03 /26/business/china-us-trade.html. 29 Roberts, Ken. 2018. U.S. Car exports to China drop 56%. Forbes. Available at: https://www.forbes .com/sites/kenroberts/2018/10/25/u-s-car-exports-to-china-2nd-biggest-market-drop-56 /#226bb8c651ad.

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The effects of the trade war on the United States have also been shaped by China’s form of retaliation, which targets products it imports from U.S. regions that provided strong political support to Trump in the presidential election and will be important for Trump’s re-election bid in 2020. As a consequence, U.S. agricultural exports have borne the brunt of China’s retaliatory tariffs.

Outside the United States, the ongoing U.S.–China trade war is depressing economic ac- tivity through decrease in efficiency from the tariffs and through decline in investment from uncertainty about future policy. Their deleterious impact on the global economy is well summed up by the title of the just-released World Economic Outlook report of the Inter- national Monetary Fund (2019)—Global Manufacturing Downturn, Rising Trade Barriers— which estimated that global growth would slow from 3.8 percent in 2017 and 3.6 percent in 2018 to 3.0 percent in 2019. Much larger negative effects will definitely emerge in the longer run if the trade conflict is not resolved soon.

If the United States and its trade partners were to drop the new tariffs erected in the last two years, would the global trading system return to its original state? We think that the answer is, almost certainly, no. Because faith in the rules-based multilateral system has been shaken, countries and ﬁrms will necessarily re-evaluate their policy positions and methods of serving markets as well as their adherence to previously negotiated agreements and their plans for future cooperation, and this reassessment will lead to changes in global trade pattern. For example, Ando and Kimura (2014) demonstrated how the increased integration of North American and East Asian production between 1991 and 2011 led to changes in sourcing patterns as China replaced Japan as the top supplier in production networks. Going forward, elevated concerns about trade policy uncertainty sparked by the trade war will lead to some decoupling of this integrated production, which relies exclusively on China.

In the long run, one thing is certain: The most enduring effect of the U.S.–China trade war will be elevated concerns about trade policy uncertainty. This is particularly unfortunate since sustained economic growth depends on careful planning that reﬂects opportuni- ties and efﬁciencies where they exist. The inability to characterize the future, as well as the potential for an escalation of the trade war that could weaponize all possible trade prohibi- tions, promises to depress world income going forward.

9. Moving on from the U.S.–China trade war

There is a broader context into which the U.S.-China trade war ﬁts. A new international economic norm is asserting itself, with the emergence of China and India as economic powerhouses alongside North America, Europe, Japan, and Russia. The emergence of a multi-polar world is changing the global geo-strategic balance and is raising concerns in

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all countries about national security. Trump’s trade wars on multiple fronts reﬂect both this heightened concern for national security and the U.S.’s hesitation about continuing its promotion of economic globalization for fear of strengthening its geo-strategic rivals. Economic disputes are a systemic feature of the present uncoordinated multi-polar political order. Our prediction is that the settlement of the present U.S.–China trade dispute will inevitably be followed by new disputes breaking out over other trade issues until the leaders of the different spheres of inﬂuence can commit themselves to the multilateral free trade system.

Our principal suggestion to China’s policymakers is that, because China is now the world’s second largest economy and a technological leader as well, there should be much greater reciprocity in China’s trade and investment relations with the advanced economies despite China’s status as a developing economy under WTO rules. China should not only give national treatment in the near future to foreign firms in a broader range of industries (e.g., financial institutions), but it should also set up a mechanism for easing limits on foreign acquisition of Chinese firms that is compatible with China’s national security concerns.

China’s continued use of WTO-sanctioned incentives that facilitate development by infant industries is no longer viewed sympathetically in the advanced countries. Fur- thermore, it is wrong to believe that China’s use of import restrictions and production subsidies have been highly beneﬁcial for China. The pervasive excess industrial capacity and the incongruous twin phenomena of inland ghost cities and coastal real estate bubbles are products of China’s production subsidies system. China’s inability to enforce hard budget constraints on state-controlled enterprises is now threatening the ﬁnancial sector with an explosion of nonperforming loans and undermining overall total factor productivity growth through crowding-out of the private sector (Woo 2019). China’s system of production subsidies has undeniably grown beyond optimum size.

On the issue of forced technology transfer, China’s use of market power can last only until the other large countries could unite and retaliate as a group. We are now seeing signs of the advanced economies moving toward a collective position on China trade. The Eu- ropean Commission (2019) has just revised its China strategy, EU–China 2020 Strategic Agenda30 adopted in 2013, to recommend that EU now adopts “a more realistic, assertive, and multi-faceted approach . . . [because China is] an economic competitor in the pursuit of technological leadership, and a systemic rival promoting alternative models of governance.” The inevitability of collective retaliation by the United States, EU, and Japan means China should quicken its efforts (1) to replace the JV mechanism for technological diffusion with other ways to strengthen its indigenous technological capability, and

30 http://eeas.europa.eu/archives/docs/china/docs/eu-china_2020_strategic_agenda_en.pdf.

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(2) to restrict state-sponsored espionage to national security monitoring and forgo its use in economic competition.

For the U.S. policymakers who are concerned about whether China trade weakens U.S. national security, we offer two observations. The ﬁrst is that geo-strategic competition is different from economic competition. Geo-strategic competition is normally a zero-sum game but economic competition, although usually also a zero-sum game in the short run, is generally a win–win outcome in the long run. Trump and Navarro should therefore stop equating these two types of competition. Geo-strategic competition should be stabi- lized, and economic competition be promoted, using specialized instruments appropriate for each objective (e.g., the weaponization of the U.S. dollar in geo-strategic competition should be used only in an all-out war).

Our second observation is that the notion of national security that is currently adopted in the U.S. trade policy debate (e.g., by Navarro and Autry 2011) ignores the primary determi- nants that shape the U.S.’s capability in technological innovation. Economic dynamism and economic resilience emerge from a vibrant domestic innovation system that is internationally competitive and not from trying to prevent other countries from achieving technological advances. The large cuts to federal spending on education and research by the Trump administration have done more to hurt the indigenous innovation capacity in the United States than Chinese cyber-intrusions.

Also, in addition to getting U.S. technological policy right, the United States must reform its social policy to reduce public alienation with globalization. A portion of national income gains need to be directed to fund strong social safety nets and well-designed lifelong learning schemes that would reduce the extreme trauma experienced by individuals who are displaced in the wake of globalization and technical change. There have to be effective state-funded safety nets to address the problem of diminished job security from cascading technological revolutions and/or the large reconﬁgurations of the international division of labor as in the 1990–92 period because the private insurance market simply does not provide coverage against these contingencies.

Finally, both the United States and China would beneﬁt from heeding Adam Smith’s foun- dational economic insight that globalization is a win–win outcome in the long-run.31 It is hence important that China and the United States lead the world in resolving the major

31 It is worth quoting Smith at length to recognize his prescience in 1776 about the return of China to the center of the world stage in the 21st century: “The discovery of America, and that of a pas- sage to the East Indies by the Cape of Good Hope, are the two greatest and most important events recorded in the history of mankind. . . . To the natives however, both of the East and West Indies, all the commercial beneﬁts which can have resulted from those events have been sunk and lost in the dreadful misfortunes which they have occasioned. These misfortunes, however, seem to have arisen rather from accident than from anything in the nature of those events themselves. At

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problems of the WTO system discussed earlier. Unfortunately, current prospects for multilateral WTO negotiations are not bright. Though the WTO has formed working groups to address some of the relevant issues such as investment measures and state-owned enterprises, progress is limited. For example, USTR (2019b) notes that many of these working groups did not meet even a single time last year, including groups for ﬁnancial services and the general agreement on trade in services (GATS). Even when meetings are conducted on a more frequent basis, fundamental disagreements between WTO members about appropriate policies, often driven by large differences on the objectives sought by de- veloped and developing countries, in conjunction with the number of WTO member states, suggest that the WTO will not be able to reform itself to the satisfaction of its membership in the medium run.

We propose therefore, as a medium-term objective for U.S. trade policy, the mobilization of country cooperation in regional settings to introduce policy innovations that would serve as templates in re-designing WTO architecture, and to harness collective market power to be used in future negotiations on WTO reform. The TPP is a good example of this regional approach to create norms governing issues ranging from state-owned enterprises to data localization, ﬁll policy gaps left by the WTO, and formulate new approaches to deal with contentious issues. The TPP had market power and hence negotiating power because its 12 members in 2016 accounted for 40 percent of global trade.32 The United States should repudiate the Trumpian habit of snatching defeat from the jaws of victory by immediately resuming membership in the TPP and becoming once again a responsible stakeholder in the global system.

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