Independent Thinking^®

Rationality and Rhetoric in U.S.-China Trade

The United States has had a long history of trade protectionism, starting with the Embargo Act of 1807, when President Thomas Jefferson attempted to punish the French and British for attacks on American merchant ships. Protectionism, as the concept is understood in modern times – using tariffs, subsidies and related measures to help make a nation’s products more competitive on world markets – reached its apex with the Tariff Act of 1930, co-sponsored by Senator Reed Smoot and Representative Willis Hawley. Smoot-Hawley placed tariffs on more than 20,000 imported goods, and many economists hold it responsible for plunging the world into a trade war and deepening, if not causing, the Great Depression.
 
Almost all economists and political scientists in the West have since agreed that free trade worldwide is good, for two important reasons. First, it reduces the prospect of warfare. Two countries that rely on each other for goods and services are more likely to resolve differences in a peaceful manner. Second, it allows the economic principle of comparative advantage to be implemented with the widest possible scope. Comparative advantage is the idea that prosperity is enhanced when we all do what we do best and make it as widely available as possible, so that we benefit from others’ expertise and productivity and let them benefit from ours. In the context of global trade, it means that if countries that excel at producing certain goods and services are free to sell them everywhere with no or limited barriers, it provides benefits everywhere, too, in the form of reduced prices and better quality for consumers and, of course, more wealth for the producers.
 
In the aftermath of the Depression and World War II, the trend toward free and open global trade persisted, fostered by landmark accords that exemplify a spirit of international cooperation, including the General Agreement on Tariffs and Trade, or GATT, signed by 23 countries in 1947, and, in 1994, and the creation of the World Trade Organization, or WTO, its much more inclusive successor framework. Both set standards for global free trade by encouraging lowering tariffs through agreements between smaller groups of nations.
 
The benefits of free trade are being taken for granted in some quarters and its merits are once again being debated. Bickering between the United States and China is causing considerable market turbulence. The wide trade imbalance, $300 billion including services, according to the U.S Census Bureau’s latest estimate, is a source of the dispute, but not the only one – and the focus by the Trump administration on using tariffs is, in our view, unlikely to correct the problem. As noted in the cover article in this issue, China is the main rival that the United States has for global influence. That rivalry is revealing a potential flaw in the theory of comparative advantage, or at least in the way the theory is being put into practice.
 
China’s focus on developing technological expertise is only becoming more acute as it pursues its “Made in China 2025” program. Launched in 2015, it aims to focus the nation on 10 key technological endeavors, including robotics, aerospace, biomedicine, and electric vehicles. Perhaps the most strategically important technology in which China is furthest behind and working feverishly to make up ground is semiconductor design and manufacturing. Last year China imported $200 billion of semiconductor chips, even as the country has increased manufacturing capacity at a very rapid rate. China has the capital to build the very latest expensive fabrication facilities, but it lacks the most advanced technology. Some small acquisitions have been made, but attempts at acquiring major companies have failed.
 
There is broad agreement that WTO rules designed to enforce fairness in trade relations are minimally effective against China’s state-led industrial base. When China entered the WTO in 2001, it accounted for less than 4% of global economic output. As a smaller and less developed country, China and its unfair trade practices were too insignificant for other countries to devote much attention to. There was also a widely shared view that developing economies needed the playing field tilted in their favor to permit them to catch up with their more mature counterparts. Catch up, China did. Today it represents nearly 15% of global output, having grown at more than double the rate of the rest of the world since entering the WTO. China’s economic rise, combined with its goal of technological dominance, has forced the United States and other developed countries to rethink the nature of their trading partnerships with China.
 
Comprehensive negotiations between China and the developed world, led by the United States, are long overdue to rebalance trade and stop the improper acquisition of intellectual property. Despite the market’s occasionally violent reactions to daily headlines, negotiations to turn rhetoric into policy will be a long process. There is evidence that China’s leaders understand that the country has been getting a good deal on global trade, but significant concessions will require a solution that allows them to save face. There is hope that rationality on both sides can overcome aggressive rhetoric, but aggressive rhetoric does open the door for an unintended policy mistake, causing an escalation that could have a serious impact on global economic growth.
 
Brian Pollak is a Partner and Portfolio Manager at Evercore Wealth Management. He can be contacted at [email protected].