Magazine | February 19, 2018, Issue

The Trojan Dragon

Why Chinese mercantilism still threatens U.S. manufacturing

Perhaps it’s the natural human aversion to bad news — sometimes known as the “ostrich effect” — but few opinion leaders on U.S. economic policy appear willing to take a cold, hard look at the state of U.S. manufacturing. If they did, they wouldn’t be happy. First, U.S. manufacturing suffered catastrophic losses in employment and output in the 2000s; then its recovery in the 2010s was only modest; and now it faces existential challenges from a resurgent China that is well practiced in the dark arts of “innovation mercantilism.”

Washington’s leading lights on trade policy have long engaged in denial on this issue, claiming that all has been well with U.S. manufacturing, even as the 2000s saw more than one-third of the country’s manufacturing jobs disappear and over 60,000 manufacturing plants shutter. Any claim of a problem was either dismissed or derided. And any suggestion that we need to fight back against foreign mercantilism, as President Trump is now doing with his announcement of tariffs on solar panels, is met with derision and tarred with the epithet “protectionism.”

So it shouldn’t come as a surprise that we are now hearing lots of happy talk about the state of U.S. manufacturing. Bloomberg News speaks of a “manufacturing resurgence.” Ball State economist Michael Hicks reassures doubters that American manufacturing is booming. And Vice President Mike Pence claims that it is “roaring back.” Administration officials can be excused for such exuberance; they want voters to have confidence things are moving in the right direction on their watch. But allegedly objective economists and journalists deserve no such pass.

It is time for the experts and pundits to open themselves up to a painful reality: The U.S. manufacturing sector has been hurt by inadequate policies at home and intense competition abroad — much of it intolerably mercantilist in nature. And China, far from cooling down, as some have claimed, is actually in the midst of a massive government-backed campaign to dominate in the most important industries in which the United States still clings to a competitive advantage — the innovative advanced-technology industries that drive U.S. global competitiveness. Anyone who thinks otherwise will likely be in for a rude awakening, for the United States has never before faced competition of such scale or scope.

Pollyannas make a number of claims that are either wrong or beside the point as they try to reassure skeptics. Michael Hicks says, “We are now at the peak of industrial production in the United States.” But this isn’t the point. From the end of 2007 to the second quarter of last year, manufacturing output actually fell, while overall GDP grew 15 percent. The fact that output was a paltry 0.2 percent higher in the third quarter of 2017 than it had been in 2007 should come as cold comfort. But it’s actually worse than that: Official government measurement of output in the computer and electronic-products sector is significantly overstated, because when a company such as Apple or Dell comes out with a computer that is twice as fast every 24 months or so, the government measures that as a doubling of output, even if the actual number of computers being produced is the same. If we omit the overstated output of the computer sector (a sector that accounted for 11 percent of measured manufacturing output in 2007), it becomes clear that the rest of U.S. manufacturing output declined by 6.4 percent from 2007 to 2016. Machinery, chemicals, fabricated metals, electrical equipment and appliances, and many other industries all produced less in 2016 than in 2007.

Journalist Rex Nutting cheers us with the fact that the U.S. “exports a lot of manufactured goods.” Indeed it does, but in 2016 it imported $752 billion more than it exported. Robert Zoellick, former trade czar for George W. Bush, writes that since “the U.S. share of global manufacturing has held at around 20 percent for 40 years,” all is well. In fact, that share is down from 28 percent in 2002.

One need only look at these and other data with a dispassionate eye to get a sense that all is not well. The United States runs the largest trade deficit in the world, and it is running a sizeable and growing trade deficit in advanced-technology goods, the very goods it was supposed to specialize in after plastic toys and T-shirt production moved to China. When measured properly (controlling for the overstatement of computer-sector output, as well as for the attribution to output of some of the growth in manufacturing-parts imports), the United States lost more manufacturing output as a share of GDP than almost any other developed nation in the 2000s. And despite recent growth, it is still 1.2 million manufacturing jobs short of 2007 levels.

Perhaps even more troubling is the catastrophic falloff in manufacturing-productivity growth. U.S. manufacturing wages are much higher than wages in developing nations. That’s possible only because America’s factories are also more productive. But competitors are not standing still. Chinese manufacturing productivity grew by 3.7 percent in 2015 (albeit at a rate down from its normal blazing clip of 8 percent). Compare that with U.S. manufacturing-productivity growth of just 0.5 percent. The sad trend is that U.S. manufacturing productivity grew 23 times faster from 1990 to 1995 than it did from 2011 to 2016. This is a recipe for continued decline.

If deniers won’t take off their rose-colored glasses when looking at U.S. manufacturing performance, they are even worse when looking at competitive challenges overseas, especially in China. The conventional response if you’re worried about China is that, as economist and pundit Paul Krugman once argued, “countries are not to any important degree in competition with each other.”

But even among those willing to acknowledge that the U.S. faces foreign competition, many are sanguine about America’s ability to win. Harvard’s Joseph Nye categorically denies that China will overtake the United States, writing that the 21st century will, like the 20th, be an “American century.” Council on Foreign Relations scholar Adam Segal suggests that “the long-term impact” of Chinese trade and innovation policies on Chinese competitiveness “remains uncertain at best,” because China doesn’t have “creative risk taking.”

These dominant views reflect an ideological conviction that only liberal, free-market economies can innovate and thrive. But as Harvard’s Peter Hall has written, there are varieties of capitalism, and there is nothing written in stone that says that a capitalism that gives massive state support to its own companies while kneecapping foreign competitors is destined to come in second.

Perhaps it was fine to turn a blind eye to these tactics when China took our toy and T-shirt production. But today the China challenge is pointed directly at U.S. advanced industries, many of them critical to our defense-industrial base. Under President Xi Jinping, China has made it clear that it seeks global dominance in a wide range of advanced industries. It has doubled down on its approach through new policy directives such as the “Made in China 2025” strategy, the “13th Five-Year Plan for Science and Technology,” and the “13th Five-Year Plan for National Informatization,” all designed to unfairly support domestic champions. As a result, the Boston Consulting Group concludes, “continued [U.S.] leadership in industrial innovation looks far less secure.” One reason is that China is on track to spend more than twice as much as U.S. firms this year on later-stage research and development. They let the U.S. fund basic research, which they swoop in and acquire by reading scientific journals and sending Ph.D. students to leading U.S. research universities, and then concentrate their massive resources on turning that knowledge into marketable products to sell around the globe.

China has a winning playbook and turns to it over and over again, racking up win after win at America’s expense. Step 1: Identify the target industry and unfairly acquire foreign technology capability through coerced transfer, commercial espionage, and cyber theft. Step 2: Ensure that domestic champions, now equipped with foreign technology, receive massive government subsidies so they can operate for years, if not decades, without profits, all the while undercutting foreign competitors’ prices. Step 3: Limit foreign access to the Chinese market so Chinese firms have time and breathing room to gain economies of scale. Only then, implement Step 4: Attack foreign markets, backed by a secure and now profitable market at home, coupled with massive export subsidies, including ones provided through the Chinese Export-Import Bank (an entity that the World Bank has funded).

This was the playbook China used to go from just 5 percent of the world solar-panel market to over two-thirds today. First it stole solar-power-technology secrets from global leaders, including U.S. companies. Next, it applied massive subsidies to domestic producers. Then it limited foreign market access. Once the industry had product and scale, it massively “dumped” cheap solar panels on the U.S. and other markets, bankrupting most of the foreign competitors. As a final step, it is using the government-enabled profits to buy bankrupt U.S. solar firms in order to strip out their technology and send it to China.

It’s the same story with aircraft. First, the Chinese government extorted valuable technology out of foreign aerospace companies by threatening to shut them out of the booming Chinese airplane market. Once equipped with technology, the government doled out lavish subsidies (free land, cash, low-interest loans, etc.) so that its leading state-owned airplane company, Comac, could operate at a loss. Now that Comac is able to produce a viable passenger jet, the government has told Chinese-government-owned airlines to buy Comac planes. Coming next is a China–Russia partnership to build subsidized wide-body jets while selling the deeply subsidized Comac planes to developing-country airlines that are more price-conscious. As the margins for Boeing and Airbus get squeezed, limiting their ability to invest less in new innovations, Comac will take the final step: displacing them in their Western home markets.

Now, think of virtually every advanced industry the U.S. specializes in (e.g., semiconductors, computers and servers, software, machinery, technical instruments, chemicals, motor vehicles, and biotech and pharmaceutical products) or wants to specialize in (e.g., electric vehicles, batteries, advanced robotics, drones, the “Internet of things,” virtual reality, and artificial intelligence) and you can get a sense of how the game will unfold: Chinese-owned companies in a wide array of advanced industries are gaining significant global market share at the expense of American (and European and Japanese) firms.

To be sure, Washington has taken some steps in the past year to reverse course and begin to regain yardage. The Republican Congress, with the support of President Trump, lowered the U.S. corporate-tax rate from 35 percent to 21 percent, allowed U.S. multinationals to repatriate foreign profits at a lower rate, and allowed firms to expense investments at once — all measures that will help U.S. manufacturers be more globally competitive. And Trump’s use of the bully pulpit to name and shame companies into moving manufacturing into the United States and keeping it there seems to have had some success.

Finally, the Trump administration’s plans to get tougher on Chinese mercantilism could mean, after two decades of Chamberlain-like capitulation, that America will finally be standing up to these egregiously unfair trade practices. We have seen that resolve very recently, when the administration announced tariffs on washing machines and solar panels. As expected, the trade-policy community has trotted out the “protectionist” epithet. But fighting mercantilism with tariffs is not protectionism; it is working to correct a foreign violation of free trade. This is particularly so with respect to the solar-panel case, in which the Chinese government cheated to take U.S. market share. The trade establishment objects also because tariffs hurt consumers. Of course they do: They are a tax on current consumption. But what about workers displaced by unfair trade practices? Do they not count?

Despite their appropriate use in some cases, tariffs do have problems. First, they are usually a day late and a dollar short. U.S. law holds that domestic producers have to demonstrate material harm before they seek relief, even if another country systemically distorts the market with government subsidies. But by then, the horse is usually already out of the barn, with mercantilist competitors having decimated U.S. production, making it hard for domestic manufacturers ever to revive, even behind a tariff wall. This appears to be the case with solar panels, since most U.S. producers are bankrupt. Second, tariffs can do more harm than good if they are imposed on key capital goods, including IT products. It’s one thing to impose tariffs on final consumer goods, where the end result is higher prices for consumers. It’s quite another to impose tariffs on such things as machine tools, semiconductors, and computers, where the end result will be fewer purchases by businesses and consumers of key productivity-enabling technologies.

The most important downside is that tariff battles might distract policymakers from the trade war. It would be a mistake if the administration’s policy vis-à-vis China were to be only a whack-a-mole response to the myriad injustices the Chinese government perpetrates. We need to focus on containing and rolling back the entire Chinese mercantilist apparatus, especially state subsidies and unfair technology acquisition. It appears that the Trump administration may be moving in that direction, with a new strategic approach to Chinese trade. This effort, however, will enjoy higher odds of success if the administration enlists its free-trading allies, particularly in Europe, to join together in the fight against mercantilism.

While all these steps are useful, to believe that they alone will be enough is ostrich-like in its own way. As the Information Technology and Innovation Foundation has stressed, we will not revive American manufacturing unless Washington does much more to ensure that the U.S. has better technology and more-skilled workers. Congress needs to increase funding for key initiatives supporting the ability of manufacturing companies in the United States to compete. These include the Ex-Im Bank, the Manufacturing Extension Partnership program, the Manufacturing USA program (a program to support industry consortia for pre-competitive R&D), and manufacturing work-force-training programs. And we need to find a way to reduce the pressure from Wall Street for quick profits, which discourages U.S. manufacturers from investing for the long run.

Much depends on restoring U.S. manufacturing greatness: good jobs, especially for blue-collar workers in the heartland; stronger terms of trade, so that America can sustain a strong dollar; and, perhaps most important, a robust defense-industrial base that will keep U.S. military power ahead of the Chinese and others. While there is no guarantee America will win, one thing is sure: U.S. manufacturing will continue to shrink as a share of the economy if elites persist in ostrich-like thinking. It’s time to get our collective heads out of the sand.

– Mr. Atkinson is the president of the Information Technology and Innovation Foundation, a science and technology think tank.

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