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Does China change the game?


It is vastly overdone to suggest that China changes the game. The challenges posed by the Chinese economy will not disappear because the U.S. puts pressure on them. The swing to statism in China's internal and external polices, however, is raising backlash abroad and driving down its growth rate at home. In the national security context, there is no one hyper-cool technology that is going to suddenly enable the Chinese to establish dominance. Technological prowess, including military capacity, is about system integration. Protectionism, instead will weaken the U.S. through cronyism, decreasing competition by statism. The sign of the self-inflicted damage from the Trump administration's policies is the marked decline in net inwards foreign-direct investment. Though troubling, it is not by itself sufficient to generate a recession.

Keywords China * Protectionism * Economics of National Security * Technological Competition


It is good to concentrate our discussion on the general issue of China-US relations. Turning NAFTA 1.0 into NAFTA 0.8, or putting tariffs on steel, or unilateralism vis-a-vis the European Union, we all know why those are bad ideas. The evidence is clear. Everything has transpired basically as the textbook would tell you. The interesting questions instead are, first, does China change the game? Does the nature of China as a very, very large economy that is not developing politically in the ways that Western people hoped for or expected mean that arguments for openness are in doubt or reversed? Secondly, as a matter of policy, was the separation between economics and national security, which has largely been the intent of the United States since the post-World War II system was set up, mistaken? Or is it at least a mistake in the current context? Thirdly, notwithstanding what among us economists here know, politically, is there a need to pursue something called 'Economic Security' in order to prevent people from chasing after bad ideas?

I think it is vastly overdone to suggest that China changes the game, whatever the intentions of the leadership of the Communist Party of China. I hold no illusions about the potential of liberal reformers of the Chinese Communist Party or the ability of outside forces to encourage them. Changing China's regime is not what this relationship is about.

The questions, instead, are whether the current Chinese regime in economics is something that is going to go away? Is this something that we can realistically hope to alter? And does its persistence present a meaningful direct threat to the U.S.? I think the answer to all three is no.

First, there is no fantasy life in which the challenges posed by the Chinese economy disappear because suddenly the U.S. puts pressure on them. That holds even if we were able to get the Europeans and the Japanese to sign onto some kind of exclusionary zone. Even in the best John Bolton case, the fact remains that China, like the U.S., is fundamentally a domestically driven economy. It is a continental economy of huge size. But also, the fact remains, trade in a sense always gets through as long as demand and large price differentials or specialized products exist.

What we have been seeing in recent months is that the reason we do not like protectionism is because of what it does to investment, and what it does to competition and corruption, in the protected society. Tariffs, in general, are inefficient, but you get around them. Trade, in a sense, goes on. And we are already seeing this, despite disrupted global value chains. Supply chains and investment sites are shifting. It probably is not as close to optimal that firms are doubling-up facilities, stockpiling, or delaying investments. Or firms which previously chose to produce goods in China are going to shift, some to Vietnam and some to Mexico. But fundamentally, that is not a huge change in the system.

Domestic productivity is why we do not want the U.S. to engage in protectionism. Almost all of us are old enough to remember what it was like when there were only American-made cars. I remember how lousy my parents' Oldsmobile was back in the '70s before there was competition from Japanese autos.

Protectionism is about cronyism, about having lack of competition internally. We are already seeing this in the U.S. This is the main reason you do not want to engage in protectionism. We can disrupt China in various ways, but it is not going to fundamentally change their basically domestic economic path. It is not going change their economy.

What these policies will do, as I argued in Foreign Affairs a year ago, and turned out to be right, is kill cross-border foreign-direct investment. The only exception will be a few countries, economies like Vietnam, that happen to gain from a bit of relocation at the margin. The world of commerce for emerging markets gets more and more hostile overall. Redundancy for international business takes a larger share of investment. This is taking place against a backdrop in which productivity growth remains historically low in the major economies.

Protectionism makes it worse. U.S. barriers are not going to fundamentally change China, which is the second issue. There is a variety of examples of different types of when we have been in a trading relationship supposedly in competition with other major economies: Germany and Japan in the '30s, Japan in the '70s and '80s, Korea later, and the Soviet Union (as it was perceived to be).

To sound a little bit neo-conservative for a minute, generally, the statist economic approaches have not done very well. Every time you look back, the statists might win short-term on the macro stimulus front. So, for example, Nazi Germany was right to do a lot of deficit spending during the 1930s, centered on public works (including rearmament) projects. That was part of why they did okay economically. But it was not their trade policy, with its attempt to build a continental system, that helped them. Go back to the work of Adam Tooze and other economic historians who have looked at this. It backfired. Just as when Napoleon tried the Continental System to stand up to the U.K.

These closed systems are horribly inefficient, they are not an advantage. You can succeed despite them. Putting it differently, people get scared about the Made-in-China 2025 proposals. That there are these ten industries, or 20 industries, whatever it is, where the Party says, we are going to make China the top in this, that, and the other global industry.

Several reasons not to be concerned:

First, every country does that--meaning issues these kinds of reports with promises. Germany issued Germany 2030. The Obama administration, as friends of mine on the CEA complained under their breath, made commitments to doubling exports in a certain number of years. I mean, this is just what governments do. That does not mean doing so is worthwhile. It does not even mean such gaudy programs matter. More importantly, when we look back at the history of these statist interventions, it is very difficult to point to a targeted industry that gained the planned success. This goes back to Paul Krugman and his colleagues' work of 30 years ago on strategic industries.

So we had government support for the Airbus-Boeing competition, but it sure as hell was not the taxpayer or the shareholders of Airbus or Boeing who won. That was the closest anybody could find to a strategic industry where there might be a winner-take-all, where there is only enough room for one-and-a-half rent-seeking players. So why are we getting so excited about all of this? If anything, the human cost of Boeing deciding it is too big to fail as a national champion has become evident--and without investment in a truly new airframe along the way.

My colleague Nicholas Lardy just published a book called The State Strikes Back. We view this as the second in what we hope is a trilogy, like Star Wars. His first book was Markets Over Mao, and it documented the fact that China got ahead, with balanced trade except for with the U.S., by opening up to markets. The second one is The State Strikes Back. The empire, under President Xi, has re-imposed statism to an astonishing degree in the last 4 years in China. And it is already showing up in China's declining economic performance, in terms of return on capital and productivity growth.

Yes, there are other reasons for the slippage. Yes, there is the ebbing of catch-up. Yes, there is demographics. But clearly, the return on assets in the state-driven, state-directed sectors is massively below the private sector, as Lardy establishes. And now, because of Xi, the share of credit and the share in production of those sectors is going up versus the private sector. Arithmetically, this is driving down Chinese growth.

The final point is that the record of using economic measures to achieve foreign policy goals is very poor. When we have tried this--the U.S., the U.K., the French, other would be empires throughout history, including China centuries ago--generally all you do is create a backlash, whether it is about intellectual property rights, compelling changes in other people's systems, or promoting demand abroad for home goods.

As I wrote about the Belt and Road Initiative 5 years ago, the best strategy is to let the Chinese overplay their hand and get into trouble, just as the Americans did in Latin America and the British did throughout their misbegotten empire. What we are seeing is that already there is more backlash and skepticism from emerging-market countries about Belt and Road. Even in places like Pakistan and Malaysia, which nobody expected to resist Chinese overtures. So do not get on the economic security bandwagon. Whatever you think of the Chinese Communist Party, and you are free, thank God, to think whatever you like, do not turn the statist overreach into a threat that justifies distorting everything in the U.S. system. As for China, we are waiting for The Return of the Jedi third episode, when Xi sees the light, and they reestablish the market.

As for U.S. policy, I will just make it very simple. I think there is a real threat that the Trump administration will withdraw from the WTO. I think they are already going beyond conscientious objection to a passive-aggressive disruption of the appellate body process. I think this reflects much more than a generic ideological belief of many Republicans that international law and organizations are inherently contrary to U.S. interests. They believe that binding arbitrations or rulings which go against the U.S. are pointless since bilaterally, the U.S. can bully people.

I think these are all mistaken ideas, but I think these are the ideas driving it. While it supports a hostile climate, it is not necessarily just to do with China. Therefore, I think there is room for a coalition across a wide range of economies, including the E.U., Australia, Japan, Canada, and Singapore, to stand up to the U.S. There are certain things that the WTO is not dealing with well with respect to China, but the WTO is just a partial regime. It deals with a certain limited set of issues, and it deals with that set well. It is terrible about creating more multilateral trade rounds, especially now that we are now getting more and more into behind-the-border issues. It is good at dispute settlement.

There was no alternative to letting China into the WTO at the time, on some conditions. What was mistaken were the fantasy promises the Obama Administration made to domestic audiences that China would have to achieve a certain kind of liberalization, both market and political. That was a fantasy. What was true was you incentivized the continued development of the private sector in China, which lifted hundreds of millions of human beings out of poverty, not just in China, and which benefited the U.S. economy. IMF entry did not create a 'China Shock' because market access barely changed. Greater certainty just increased mutually beneficial investment.

Then there is the issue of the risk of supposedly critical technologies falling under the control of hostile parties. The discussion of technology we seem to have these days, particularly in Washington, especially if you encounter foreign policy or international affairs types, is kind of analogous to decades-old thinking about Pepsi versus Coke. To wit, that there is this secret formula for Coke, and once you get that formula, then you can improve on it, or cheat, or just make the same thing as the other guy has and get caught up. I mean, I sometimes use the more negative example of this from the 1940s of Klaus Fuchs going in and taking spy pictures of the plan of the atomic bomb, and then the Soviets got the Bomb. But this, of course, is a complete misrepresentation, a mistaken view of technology, both in the national security context and in the economic context.

In the national security context, there is not one hypercool technology that is going to suddenly enable the Chinese to get ahead and ruin U.S. air superiority or have 18 aircraft carriers. Defense capacity is primarily about systems integration, training, and communications. This is why Israel and Norway are both seen as capable of massive self-defense, even though they are mostly buying other people's technology. Per capita GDP is a better proxy for military strength than GDP in many ways. So even though the two are small by comparison in economic terms to the nations surrounding them, that does not map into true national security, except in a World War II global, long-duration conflict scenario. I repeat, economic power does not map directly into national security.

Second point is, if you think about it in economic terms, again go back to Pepsi versus Coke. Most of us, believe it or not, if we took the Pepsi Challenge would not be able to tell which was Pepsi or which was Coke. The way the money gets made by those companies is by the brand, the associated networks, the values, and the distribution, and all of those things. That is even true of Facebook, and almost all the other major multinational companies. Initially, Google was this breakthrough in search, but now Google makes money from being Google. And so the idea that "The Chinese," (which is already a misnomer) reverse-engineer or "steal," quote-unquote, some piece of technology, that does not immediately catapult them to world leadership in a given industry.

Let us not forget, the U.S. industrial base started with us stealing the technology for doing woolen manufacture and changeable parts from the U.K., protected under the Manufactures Act. The British Raj decided to steal the G.M.O. of the day, which was tea, from China, in order to plant in India, so they would not have to pay China for tea. So again, technological competition is not about one company complaining because their trademark-patented product got stolen. And it is unrealistic to keep technology from spreading. The source of value-added is the business and network around a given brand. That is not a national security issue. Having a hostile power have access to your I.T. network is a security issue. But that is about Russia and North Korea as much as or more than China. That is a security issue narrowly defined. It is certainly not about the economic power or technological competitiveness of North Korea or Russia.

As to tariffs, under most circumstances, exchange rate shifts will offset their effects almost one-for-one. Tariffs are not a macroeconomic shock that can change trade balances. Unless you are Britain and you decide to totally withdraw from trade with your predominant trading partners across the entire range of industries. That would be a macro-shock.

What has been the effect of the administration's protectionist policies? I wrote a piece for Foreign Affairs a year ago about the post-American world economy in which I emphasized the issue of cross-border and business investment. Six months later, the Foreign Affairs editors came back to me and said, okay, you talked about all of this stuff. What would be an indicator that this Trump approach is starting to bite? I thought about it and I said, well, probably what would happen would be a cratering of net foreign-direct investment into the U.S.

I looked at the data and it turns out that, indeed, U.S. foreign-direct investment did crater, basically, since Trump won the election, on net as well as in level. This is despite it not having gone down that much from China in 2017-2018. Foreign direct investment even went down despite corporate tax cuts, that in any reasonable model, if you think they have any effect at all, should make it relatively more attractive to put corporate money in the U.S. Net inwards FDIs went down despite the fact that we had a strong growth environment. So this swing to protectionism erodes competitiveness. It erodes more importantly, because I hate that word competitiveness, productivity.

While the drop in direct investment is real, it is not an obvious large-scale macro-shock. I assure you, there are people who are very pro-free trade, who wish I, and the Peterson Institute, would come out and say, we are going to have a recession because of the trade war. The fact is that would be an exaggeration. A recession is not going to happen for that reason alone. But you are seeing much less investment, and lower productivity of investment, and less preference for the U.S. as a result of the trade war.

Publisher's Note Springer Nature remains neutral with regard to jurisdictional claims in published maps and institutional affiliations.

Adam S. Posen is the president of the Peterson Institute for International Economics.

Adam S. Posen (1)

Published online: 13 May 2019

Prepared from remarks at the session Can American Economic Security and Global Growth be Pursued Concurrently? at the NABE Economic Policy Conference, February 27, 2019.

[mail] Adam S. Posen

(1) Peterson Institute for International Economics, Washington, DC, USA
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Author:Posen, Adam S.
Publication:Business Economics
Geographic Code:9CHIN
Date:Jul 1, 2019
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