How the Return of Unrestrained Capitalism Eroded the Foundations of Global Trade (Note: this post is a shortened and streamlined version of a longer essay posted here.)
With his threat to impose huge new tariffs on China tomorrow if China reaches no trade agreement with us, President Trump has all but challenged China to a trade war. But war never solved any problem. War always makes things worse, either by deepening the underlying dispute, by creating new problems (such as demonization, destruction and death), or both. The key to solving our trade problems with China is to understand what went wrong with global free trade.
The longstanding theoretical basis for international trade is the concept of comparative advantage. Every region, the theory goes, makes some things better or cheaper than others. For example, California’s Central Valley, the American Midwest, and the pampas of Argentina all have ideal terrain and climates for growing crops. So they have become the world’s “breadbaskets,” trading grain and other crops on several continents.
If these regions trade their crops for manufactured goods made cheaper or better in (for example) Germany or Japan, everybody is better off. Germany and Japan get food that is cheaper or better than their respective climates and terrain allow, and the crop-growing regions get high-quality manufactures that they can’t or don’t make themselves.
Each region benefits from receiving goods that enjoy others’ comparative advantages. The same concept of comparative advantage applies to services.
Trouble arises with free trade in technology and intellectual property. When a nation’s or region’s comparative advantage arises from its own innovation in technology, the intangible technology, too, can be traded. Today, firms can trade and transfer technology instantaneously and nearly costlessly over the Internet.
But too free trade in technology can allow others with different advantages—such as cheaper labor—to produce goods and services using the same technology cheaper or better. This erodes the innovator’s comparative advantage. It also erodes the financial incentive to innovate, which is the worldwide purpose of legal protection for intellectual property in the first place.
This is precisely what has happened between the US and China. China’s huge population attracted trade from American capitalists. Using underarm deodorant as an example, they called it the “2.8 billion armpit” market, based on China’s current population approaching 1.4 billion.
A market that big makes American capitalists salivate as they seek new places to sell things. So they looked to China as a good place to make huge new sales and profits.
But China had, and still has, another comparative advantage: cheaper labor. To exploit that advantage, American capitalists decided to build plants in China and hire Chinese workers to make their goods.
The wage differential between China and America turned out to be greater than the costs of packaging and shipping most goods back to the United States. So American capitalists, ever conscious of economy, started using their Chinese plants to supply the United States as well.
This, in essence, is the story of how American manufacturing hollowed out over the last generation. It’s also the story of how China, by employing workers in American-built and/or American-financed factories in China, raised hundreds of millions of Chinese citizens from poverty into the middle class.
Whose “fault” was it? Does it matter? In truth, American capitalists, the Chinese government, and private Chinese businesses all participated in the process enthusiastically. None, apparently, foresaw the unintended consequence that manufacturing plants and jobs would migrate en masse from America to China, weakening the American middle class and causing American small towns dependent on single manufacturing plants to dry up and blow away. No one foresaw that this process would culminate in a very angry American working class voting to elect Donald Trump as president.
But the process is still going on. The jobs that migrated to China are not coming back. Wages levels in China, although rising, are still lower than in the United States, and China’s still-primitive legal protection for labor and the environment makes manufacturing for most things cheaper in China. Until these conditions change substantially—which could take a good part of this century—China will have a labor-cost advantage which will keep most of this manufacturing there.
In theory, the United States could counter this labor-cost advantage with a comparative advantage of its own. The United States is the world’s most innovative nation. As we innovate new products, newer and cheaper ways of making things, and whole new categories of goods (like the iPhone), we could produce unique goods to trade with China in exchange for existing, common products that Chinese plants make more cheaply with cheaper Chinese labor.
But what happens if we Americans trade our new technology, i.e., our innovations, too? Then we have no comparative advantage except, perhaps, in trading food from our “breadbaskets.”
Then all of our great inventions will migrate to China for manufacturing, because Chinese labor is cheaper, there are lots of Chinese still seeking work, and our own capitalists can make our own inventions more cheaply there. In other words, free trade in technology will rapidly erode our best and most promising comparative advantage in trade in goods and services: our innovation. Then jobs and factories arising from our own inventiveness will spring up in China, not at home.
This is not just theory. It is fact. Look at the box your iPhone came in, or its instructions. They say that the device was designed in California. But it was made by Foxconn in China.
Not only does this state of affairs devalue our principal comparative advantage as a nation: our innovation. It partially circumvents the (now-globalized) legal protection for technology, principally patents and copyrights.
As our Constitution recites, the purpose of that legal protection is to “promote the Progress of Science and useful Arts,” by giving inventors, not others, the commercial advantage of their discoveries for the duration of legal protection. Yet free trade in technology, as distinguished from free trade in goods and services, undercuts this purpose by giving major advantages of American discoveries to non-inventors: lower-cost Chinese workers and the Chinese nation.
We can argue all day about whose fault this is. In truth, it’s everyone’s fault. The Chinese saw a way to jump-start their manufacturing economy using the magnet of their labor-cost advantage. What smart country wouldn’t exploit that advantage? American capitalists, unrestrained by American law or policy, saw a way to make their innovations as cheaply as they could, opening markets not only in China but, by virtue of the Chinese production-cost advantage, all over the world.
American capitalists willingly approved the vast bulk of this technology transfer because of the money it helped them make. It’s only been recently, when the Chinese began to sense the door of unrestrained technology transfer closing, that they began resorting to cyber-espionage, bribery and theft to obtain new American technology.
Anyway, the solution to this problem is not war, whether in trade or otherwise. Destruction is never a good solution to anything, and war inevitably causes destruction. Even a “peaceful” trade war would destroy much of the intricate global supply, manufacturing and distribution chains that arose over the past few decades, perhaps causing a global recession.
The solution is not to throw bombs or make war, figuratively or otherwise. It’s to restore the rightful comparative advantage of America’s innovation machine. How do we do that? We Americans must make plans, not war.
We must make plans to require our own capitalists to keep and manufacture their innovations at home, at least for a time sufficient to establish a solid first-mover advantage. Once plants in America have climbed the manufacturing learning curve here, and once their doing so has attracted many educated experts in the field from around the world, it might be time to let foreign plants compete in making our inventions, if they can. The lead time that our policies and laws ought to require might vary with the innovation, but it would probably be at least ten years.
The crux of our discontent is not free trade. Trade in goods and services is mutually beneficial. It’s the principal means by which different human cultures interact on a daily basis. It lets each city and region enjoy the benefits of every other’s comparative advantages. And it’s much more pleasant and constructive than war.
The crux of the matter is that, for decades, our law and policy has allowed, if not encouraged, American capitalists to “trade away” our nation’s principal comparative advantage: our world-leading innovative spirit. The result has been to undermine the basic theory of global trade—comparative advantage—but in a way that disadvantages the United States in particular.
The responsibility for correcting this blunder is not China’s. It’s our own. It’s a job for Congress and our president.