Politics & Policy

Fight the Dragon

(Imaginechina via AP Images)
China is waging war on free trade.

The standard economic model treats free trade as obviously positive, creating prosperity for all participants. Conservatives, and most neoliberals, have embraced that view and consistently press for further liberalization while condemning as backward and reactionary “protectionism” any proposed obstacles to the free flow of goods and services. But the model is incomplete, and blind allegiance to it only weakens the U.S. economy and the health of the international trading system as a whole.

Rather than an easy win-win for all involved, trade policy presents a variation on the prisoner’s dilemma, the classic game-theory problem in which two people must choose whether to cooperate with or betray each other. Each has an individual incentive to betray, but responding to those incentives and betraying leaves both worse off than had they cooperated. 

So it is with the global economy and specifically with China and the United States, its two dominant players. As any economist’s model demonstrates, both nations will benefit from greater wealth if they build strong trade ties and open their markets to each other. But while the United States strives to cooperate by opening its market, China has chosen betrayal. It restricts access to its market, aggressively subsidizes its domestic producers, and shamelessly expropriates intellectual property, all while manipulating its currency and loaning the ensuing surplus of dollars back across the Pacific to the United States.

Just as the betraying prisoner goes free while leaving the cooperative one behind in a jail cell, China has produced unprecedented economic success at the expense of the United States. In 2009 it overtook the United States as the world’s largest exporter, in 2011 as the largest manufacturer, and this year it may be declared the world’s largest economy. The U.S. economy, meanwhile, will likely stagger in 2014 to its ninth straight year of less than 3 percent growth, after having experienced only one such stretch of even four years since World War II. Other open, Western economies face similar challenges, while other developing nations watch China’s success and dream of emulating it.

Fortunately, today’s challenge differs from a prisoner’s dilemma in one important respect: Rather than choosing a strategy once and living with the consequences, the players are in a “repeated game.” The United States need not allow itself to be taken advantage of forever, or assume that China and its followers are irrevocably committed to their course. To the contrary, America and her allies have the opportunity to make clear that they will no longer play on these terms, that they would rather take their ball and go home than continue to compete on a tilted playing field, and that it is the cheaters who must decide whether they will finally comply with the rules or be ejected from the game.

Forcing such a decision is not “starting a trade war” any more than committing to the defense of one’s borders constitutes an invasion. Indeed, far from being protectionist, threatening nations like China with severe trade sanctions is critical to ensuring a prosperous future for the global economy.

The international trading system is governed primarily by the World Trade Organization (WTO), an international body, created in 1995, with more than 150 member nations. In theory, the WTO guarantees that all nations engage in free trade under the same rules and receive reciprocal benefits from their trading partners. In practice, it does nothing of the sort.

The agreements covered under the WTO at the time of its formation provide only limited protection for trade in services and for intellectual property, the bedrocks of U.S. economic strength, and were always intended to evolve through subsequent negotiations. Unfortunately, no such evolution has occurred — in its 20 years the WTO has failed to take a single step forward on trade liberalization. Expectations have fallen to the point where a recent, unremarkable streamlining of customs procedures led the organization’s head to declare: “For the first time in our history, the WTO has truly delivered.”

Nor does the WTO provide an effective enforcement mechanism for those rules that are in place. It does not have the power to enforce penalties against nations whose policies defy existing agreements. Rather, after lengthy litigation and appeals processes, a nation wronged by another wins only the right to retaliate in kind — an approach to conflict resolution typically left behind sometime around kindergarten. Any such retaliation may then itself be the target of further litigation.

Prospects for future progress are no better. Any agreement would require unanimous support from all 157 nations — support that is not forthcoming from those that benefit from the existing weaknesses. In short, the WTO has become little more than an economic United Nations, an ineffectual debating society beholden to agendas running directly counter to the organization’s supposed purpose.

Since joining the WTO in 2001, China has ruthlessly exploited the free-trade system’s reliance on mutual trust and goodwill, wreaking havoc in the markets to which it gained access while bullying entrants in its own market. Its economic strategy falls within three broad and complementary categories: market distortion, intellectual-property theft, and currency manipulation.

Market distortion comes naturally to China, a Communist country with a barely market economy dominated by state-owned enterprises. While its WTO commitments establish the official tariffs it can impose on imports, they are unable to restrain it from placing importers at other insurmountable disadvantages when attempting to sell into the Chinese market. China designs regulations and establishes technical standards that its domestic producers can more easily meet, provides direct subsidies to give those producers a financial advantage, and slows the approval of foreign products. It establishes “local content” requirements that force foreign firms to set up shop within the country and enter into joint ventures with local companies, rather than manufacturing at home and exporting the finished goods to China. And it ensures that government procurement gives preferential treatment to local firms — no small matter in a state-run economy where the government is often the primary consumer.

#page#As a result, China pays its “dues” into the global economy by offering up a massive domestic market that is in theory open but in practice closed to competition. The situation is only worsening. The Economist announced in a cover story earlier this year that “China loses its allure,” noting that while “China’s government has always made life difficult for firms in some sectors . . . the tough treatment seems to be spreading” and companies are being forced to pull out.

Even when American companies do have the opportunity to enter the Chinese market, they are rightly reluctant to do so for fear of falling victim to the pervasive intellectual-property theft that the Chinese government permits and in many cases facilitates. It is official Chinese policy to promote “indigenous innovation” by forcing foreign firms to transfer their technology and trade secrets to local Chinese companies as a condition of doing business in the country. The U.S. Chamber of Commerce had described the policy as “a blueprint for technology theft on a scale the world has never seen before.” Meanwhile, the government provides little to no enforcement of protection for foreign firms that find their patents and trademarks ignored by their Chinese counterparts.

Nor does staying away from China provide a respite; China’s market distortions and intellectual-property abuses come home to roost in the U.S. market as well. A subsidy that advantages Chinese firms in China gives a similar advantage to those firms when they export across the Pacific. And China is actively pursuing an unprecedented global campaign of industrial cyber-espionage, targeting thousands of U.S. companies as diverse as Google, Coca-Cola, and the New York Times. The issue has risen to the top of the U.S.–China economic dialogue as hundreds of billions of dollars’ worth of intellectual property has been seized through centrally coordinated Chinese cyber-attacks that have given Chinese firms access to their competitors’ strategies. In a stark sign of that dialogue’s failure, the U.S. Department of Justice last month indicted five Chinese-military officials for cyber-attacks on the proprietary data of American steel, solar, and nuclear-power companies.

One can read through page after page of case studies, compiled at the request of Congress by the U.S. International Trade Commission, that detail how Chinese policies are systematically eroding the position of crucial American industries — software, telecommunications, automotive, aerospace, renewable energy — by blocking their market access and appropriating their technology. Ironically, one of the report’s few examples of successful participation by a U.S. exporter in the Chinese market was American Superconductor (AMSC), a provider of wind-turbine technology to Sinovel, the largest Chinese wind-turbine manufacturer. But today, the two firms are embroiled in multi-billion-dollar litigation across two continents. AMSC accuses Sinovel of outright stealing its software and building it directly into the Sinovel products — as it discovered after Sinovel abruptly canceled all of its AMSC contracts and Sinovel turbines showed up in Massachusetts running the (allegedly) stolen software.

Underpinning this systematic perversion of a supposedly free-market trading system is a program of intensive financial engineering that allows China to maintain an enormous, otherwise unsustainable trade surplus with the United States. Last year, China exported $440 billion in goods to the United States while importing goods worth only $122 billion — an imbalance of more than $300 billion at a nearly four-to-one ratio. In theory that should not be possible: An excess of U.S. dollars should build up in China while a shortage of Chinese currency develops in the U.S., driving up the value of the Chinese currency and therefore the relative cost of Chinese goods so that the trading relationship rebalances. Instead, the Chinese government manipulates its currency, extracting the dollars and in many cases turning around and lending them back to the U.S. government to finance the federal budget deficit.

The combined effect of these Chinese policies applies a pincer movement to the U.S. economy. From the supply side, the U.S. market is flooded with cheap foreign goods that drive domestic firms out of business. Lower prices are generally desirable, and one might think that if China wants to send over subsidized products, often on effectively free credit, then Americans should gladly accept the offer. But this represents a form of predatory pricing — a tactic rightly banned under antitrust law — on a geopolitical scale, and the resulting long-term cost in destroyed firms and eroded economic strength greatly exceeds any short-term benefit.

From the demand side, U.S. employers that might have employed U.S. workers and exported the resulting goods and services to China are instead forced to set up shop in China (often in joint ventures with Chinese firms), which is unsustainable in the short run for U.S. workers who are now unemployed and in the long run for the firms that succeed only at the pleasure of the Chinese Communist party and, in the process, give up their intellectual property. Even where U.S.-based multinational corporations are able to position themselves for long-term success, the ensuing profits are most likely to be held and reinvested overseas, away from the U.S. tax and capital bases. Ensuring that the American people share broadly in that prosperity would require an aggressive redistribution of wealth from the owners of those corporations to their (now unemployed) former work force.

As the Chinese economy grows ever larger, its technological capabilities expand, and its policymakers become emboldened by the world’s acquiescence, the situation only becomes more dire and the U.S. ability to respond more constrained. One can hear in this warning echoes of largely overblown fears raised by Japan’s economic rise several decades ago. The devastation Japan wrought on major U.S. industries was real, however, and its success helped to blaze the trail that China follows today. China, led by a political regime fundamentally incompatible with America’s, is ten times larger than Japan, its abuses are more severe in degree and in kind, and it is steamrolling its path into a freeway down which many more nations will enthusiastically cruise. If China is the next Japan, the United States should be very worried indeed.

#page#The issue of currency manipulation has become a symbolic flashpoint in policy debates not because it is the most serious of the Chinese abuses but because it is the most obvious instance of America’s failure to take Chinese abuses seriously.

Almost no one disputes that China manipulates its currency. The U.S.–China Economic and Security Review Commission, a federal body established by Congress to monitor the economic relations between the two nations, stated plainly in its last annual report that “China continues to manipulate the value of its currency, the RMB, to achieve a competitive advantage with the United States.” In its semi-annual report on currency manipulation, released in April, the Treasury Department declared China’s currency “significantly undervalued” and noted “continued [Chinese] actions to impede market determination.” Chinese policy appeared to be worsening, and “recent developments,” it said, “raise particularly serious concerns.”

But as in every other report of the past two decades, the Treasury Department refused to call a spade a spade and officially designate China as a currency manipulator, for fear of offending the Chinese. Therein lies the root of the problem. Even as China thumbs its nose at the international trading system and surges forward economically at U.S. expense, the consensus remains that the United States should do nothing to respond lest it provoke China’s ire. The situation is so sensitive, evidently, that even taking the extraordinarily tepid step of assigning the (entirely accurate) label of “currency manipulator” could trigger a painful response. And yet, if China knows that it will face no consequences for even its most blatant and undeniable abuses, who can blame it for taking an ever more aggressive approach?

China has found itself an ideal arrangement, in which it betrays while the United States cooperates. It has calculated — correctly, so far — that faced with this betrayal the United States will opt to continue its cooperation anyway rather than risk open economic conflict. But this arrangement is not sustainable. The international trading system is not self-enforcing; it is a reciprocal construct in which only the prospect of benefits denied compels each nation to operate within the rules in a manner that can make all nations better off. If the threat of retaliation is not credible — if large economies so fear the possibility of a trade war that they would rather simply surrender — then more and more countries will flout the rules more and more aggressively and the system will unwind.

This dynamic is not unique to the economic sphere. It is the same one that plays out in potential military conflicts, where a credible willingness to meet force with force is critical to deterring aggression in the first place. As long as nations prefer peace to war, the peace is kept. But if Nation A believes it can choose force that will be met not with force but with complacence, using such force suddenly becomes the most attractive option. It is in this moment, when Nation A chooses force, that Nation B must decide whether to fight back.

There are always those calling on B to tolerate the provocation as preferable to open conflict. The word for such an approach is “appeasement.” In the military context conservatives generally reject it, recognize that removing the consequences for aggression only invites further aggression, and argue for imperiling American lives in defense of the national interest. Yet somehow, when the topic turns to trade and it is a quarterly profit statement potentially imperiled, bold declarations of “peace through strength” turn into squeamish equivocations about the need for dialogue.

Perhaps once upon a time, when China’s economy was small, its violations were a mere inconvenience unworthy of response. But that time has long since passed. China’s strategy is causing severe, permanent damage to the U.S. economic interest, and the United States needs to make clear that, faced with such misconduct, its choice will be retaliation rather than tolerance. China will then need to decide whether to return to a peaceful equilibrium in which all sides play by the rules or to continue down its current path and destroy its economic relationship with the United States.

Given only those two options, following the rules would seem the obviously more attractive one for all involved. That is the hope and the goal — not actually to retaliate but rather to create conditions under which betrayal is no longer contemplated by either side. But the crucial point is that if China does in fact prefer an open trade war to genuine free trade, then collapse of the economic relationship is inevitable. With a country that prefers a trade war to free trade, the United States has no better hope of maintaining a beneficial relationship than it has of keeping the peace with a country that prefers war to remaining within its own borders.

The typical condemnation of such an approach as “starting a trade war” represents a nonsensical form of economic pacifism. The trade war has already started, but only one side is fighting. The question for the United States is whether to respond or surrender, bearing in mind that a response has a good chance of defusing the conflict, whereas a surrender will only embolden nations with no commitment to free markets, undermine the health of the trading system as a whole, and leave the committed free-traders to fight on far less favorable ground at some point in the future.

If America will not respond to the current abuses, when will it respond? When China’s economy is dramatically larger, less reliant on exports, and supported by robust alliances with other mercantilist nations? When China announces it will no longer purchase American drugs and will instead manufacture its own versions locally? When the first Chinese commercial airliner rolls out of the hangar, looking suspiciously similar to Boeing’s latest model but available at half the price?

The United States needs a comprehensive arsenal of retaliatory economic weapons that it can credibly threaten to use if China (and, in the future, any other nation) does not quickly and sharply alter its course. Some of these weapons it can develop and deploy unilaterally. Others will rely on coordinated action among developed economies to achieve the desired effect without disadvantaging U.S. producers. All should be designed as ratchets that can apply increasing pressure — the goal, after all, is not to actually use any of them or to do damage but only to make clear to the Chinese that the threats of such action are credible.

UNILATERAL U.S. ACTION


The United States should create structures that enable broad-based retaliatory actions against the government subsidies and intellectual-property theft embedded in Chinese exports, while also applying maximum pressure at discrete points where it has the most leverage. The best leverage point is America’s higher-education system, access to which is desperately coveted by the Chinese and is a critical ingredient to their technological advancement and economic development. More than 200,000 Chinese nationals studied at American universities last year, representing more than 25 percent of all foreign students (though only about 1 percent of total enrollment). None of these students need be expelled, but visas for new entrants should be sharply curtailed and ultimately cut off. Such a move would pose no threat to America’s academic preeminence, but it would badly damage China’s human-capital development and focus the injury directly on the Chinese elite with the most leverage over their nation’s policy.

#page#A second leverage point is the American life-sciences industry, which produces an extraordinary array of technologies for which there is often no substitute. While China’s health-care system is still in its infancy, the country will increasingly seek to provide access to these products — particularly for its wealthier citizens. The U.S. should bar manufacturers of the most sophisticated and difficult-to-replicate biologic treatments from discounting their prices in the Chinese market below what they charge to private-sector U.S. insurers. So long as China is running a $300 billion trade surplus, it can surely afford to pay list price. The U.S. should also bar those manufacturers from establishing production facilities in China, lest the technologies be “transferred” to domestic Chinese producers. U.S. firms might find themselves with a limited Chinese market, and China might attempt to produce generic versions of the treatments, but both outcomes are likely (and more attractive to China) under current policy as well.

More broadly, the U.S. should designate China as a currency manipulator and then classify that manipulation as an illegal subsidy that benefits all Chinese products entering the U.S. market. Such a finding would give the Department of Commerce authorization to impose a countervailing duty — i.e., a tariff to offset the subsidy. The result would be a tax of likely 20 to 30 percent applied to all imports from China, phased in gradually over a number of years. This would drive prices in the United States back toward market levels while reducing the advantage enjoyed by Chinese firms. It was the threat of similar action in 2005 that first led China to relax its currency peg and allow the RMB to appreciate significantly.

The U.S. should also create a process through which Chinese firms can be designated as beneficiaries of intellectual-property theft in either their products or their processes, and such firms should be barred from selling products in the U.S. market or from accessing U.S. capital markets. A finding that Chinese cyber-espionage has targeted an industry in which the Chinese firm competes, supported by evidence from American companies that demonstrates the type of intellectual property that has been stolen, should be treated as sufficient to create a rebuttable presumption that the Chinese firm has benefited from the theft. Chinese firms could be offered a limited time frame and process for clearing their names and demonstrating the integrity of their products.

MULTILATERAL ACTION

Bringing the world’s developed economies together to pressure China will greatly amplify U.S. leverage, both because the magnitude of threatened economic disruption will be greater and because it will make Chinese retaliation far more difficult. Where the United States acts alone, it risks Chinese retaliation against U.S. firms, leaving them at a long-term disadvantage against other competitors in the Chinese market. Where nations act in concert, they can do so without fearing such a consequence. And while none have been harmed by China’s approach to trade as much as the United States has been, all would benefit greatly from the successful curtailment of those abuses.

The most powerful step that the world’s developed nations could take would be to form a multi-party free-trade agreement that encompasses all of their economies while excluding China and other nations that exploit the trading system — essentially, a trade-focused analogue of NATO to complement the U.N.-like WTO. The agreement would be “open,” meaning that it would establish clear standards in critical areas such as services trade, capital-market regulation, and intellectual-property protection and would offer membership to any nation willing to abide by its terms.

Such an agreement would have immediate value to those nations committed to the principles of free trade, allowing them to make significant progress on strengthening the free-trade system outside the WTO framework. The agreement would place substantial pressure on China, excluding it from a host of economic benefits made available to its competition and making it an unattractive node in international production networks. And the agreement would provide a forum in which to coordinate other actions.

The first such action should be the establishment of intellectual-property sanctions to bar the introduction of sensitive technologies into the Chinese market, where they would likely be expropriated. Such policies already exist for sensitive military technologies under the Wassenaar Arrangement and are employed case by case in the application of other sanctions regimes (as with efforts to prevent nuclear technologies from reaching Iran). To China’s indigenous-innovation policy, which clearly identifies the industries whose intellectual property it intends to take — aerospace technology, biotechnology, etc. — other nations should respond by refusing to allow their firms to transfer such technologies into the Chinese market.

Finally, the U.S. and its allies should restrict access to their capital markets for Chinese state-owned enterprises and firms identified as benefiting from subsidies and intellectual-property theft. China’s own capital markets are no match for their Western counterparts, and depriving Chinese firms of access to both management discipline and sources of funds would hobble their growth while denying them important symbols of economic status. Nations should also restrict the terms on which their firms may bring foreign direct investment to China, further constraining access to capital and know-how. And they should block Chinese investment into their own economies in sectors where China does not accept unfettered incoming investment. Particularly in the current interest-rate environment, China needs those investment opportunities — to manage its capital flows and to gain strategic ground — far more badly than developed nations need China’s capital.

It must be stressed again that the goal in developing each of these tools is not to use any of them. The United States should not want to exclude Chinese students from its schools, to impose tariffs, or to restrict access to medical technologies or capital markets. But developing these tools is every bit as important as developing the next generation of military technologies, and being prepared to use them is every bit as important to preserving the international system.

The United States should begin by clearly outlining what it expects of China and what steps it will take, on what timeline, if those expectations are not met. Assigning the formal “currency manipulator” designation would be a good first step in demonstrating that the game has changed. But more-substantive steps would need to follow close behind if Chinese practices continued as before.

This course of action risks an escalation by China, either because it would truly prefer an all-out trade war to good behavior within the trading system or because it hopes that the U.S. could be scared back into capitulation. But China, already committed to an offensive strategy, has only so many more levers left to pull. It already distorts its market as aggressively as it believes wise and steals intellectual property as rapidly as it can. Firms are already abandoning the Chinese market; forcing them out has only so much effect. Bringing WTO cases against the United States would be of little value to China when victory would only entitle it to withdraw concessions it has never truly made. While some analysts look at China’s massive holdings of U.S. debt and currency and fear that it could use these tools to gravely harm the U.S. economy, that assessment badly misconstrues China’s leverage as the party that has made the loans and needs the assets to retain their value.

If the U.S. were forced to move forward from threats to action, it would no doubt experience significant economic pain as well. Some firms would be hurt. Some consumer goods would become more expensive. Some economic disruption would occur. But that is the inevitable result when a bad actor in the international system forces a conflict of any kind. Tariffs and other market interventions are blunt, inefficient tools, made more so by the political machinations that will accompany their use. But that is an unavoidable cost of the large-scale government action that such a conflict demands.

Freedom isn’t free, and neither are free markets. If a resilient, free-market system of international trade is worth fighting for, the United States must be prepared to fight for it.

— Oren Cass was the director of both domestic and trade policy for Mitt Romney’s presidential campaign. This article is adapted from the June 23, 2014, issue of NR.

Oren Cass — Oren Cass is a senior fellow at the Manhattan Institute and the author of the forthcoming book The Once and Future Worker.

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