The unwisdom of economic retaliation against China
Oren cass’s argument for threatening trade sanctions against China (“Fight the Dragon,” June 23) begins to go wrong from its very first words. He allows that the standard economic model of trade is correct in holding that all countries are better off if all practice free trade, but he says the model does not account for the fact that a country that refuses to practice free trade can reap benefits at other countries’ expense. Free trade thus presents a prisoner’s dilemma.
Cass himself is prisoner to a misconception, for he does not understand the model he is criticizing. That model does not ignore the possibility of a prisoner’s dilemma but rather denies that it exists. After all, the classical case for free trade was developed in a mercantilist world, and it argued that free trade almost always benefits the country adopting it, regardless of the trade policies of other nations.
This insight allows us to break free of the common metaphor of trade policy as war. For an economy as large and diverse as that of the United States, dropping a tariff is not like dropping a shield in a swordfight; rather, it is refraining from inflicting a wound on oneself. Cass does not refute this well-worn case; he ignores it. He takes the military metaphor to its limit and then beyond. If the United States does not raise taxes substantially on the customers of Walmart, he says, we are acting like pacifists and appeasers. He even expresses puzzlement that “somehow” we respond differently to threats of reduced profits for American companies than to threats of actual force.
Almost all of the flaws in Cass’s argument follow from these mistakes. Because he thinks of imports from China as a kind of invasion, he exaggerates the harm that trade causes us, and he proposes a course of action that is far less likely to reduce those harms than to inflict some of its own.
Which is not to deny that he makes other mistakes. He argues, for example, that “in theory” a persistent trade imbalance should not be possible in the absence of currency manipulation. This is untrue. China sells the United States goods and receives dollars in return. There is no reason “in theory” that China should use those dollars to purchase goods. It can, for example, purchase U.S. government debt — which it does. Cass implies that this action (along with currency manipulation) is somehow foul play. Of course it isn’t. And any economic model that denied that trade imbalances could persist would be dubious, as all you have to do is look out the window to see plenty of persistent trade imbalances. (Yours with the grocery store, for example.) If your model predicts that the sun won’t rise tomorrow, you should throw it out tomorrow afternoon.
Cass’s essay makes it sound as though U.S. trade policy and the policies of other countries determine the U.S. trade deficit. They do not. A nation’s trade balance is determined by how much households, firms, and the government save and invest. If investment exceeds saving, the country will import more than it exports: The capital-account surplus will mirror a trade-account deficit. This isn’t a theory and it isn’t a policy: It is a fact of national income accounting.
It is thus not at all true that protectionist countries will run trade surpluses and free-trading countries — the chumps of Cass’s story — will run deficits. The United States in the late 19th century ran deficits while also maintaining protectionist tariffs. As that example also suggests, persistent trade deficits are not a sign of national decline either.
Cass’s portrait of a hapless United States too sunk in pacifism to respond to the gathering economic threat of China is also poorly timed. China’s currency has been appreciating for several years now — a fact he notes, without reconciling it with his general description of relations between the two countries — and the ratio of imports to exports in our trade with China has been shrinking as well.
Other recent events undercut Cass’s description of China’s offenses still further. The U.S. has pursued a highly discretionary monetary policy in recent years, and to the extent that this policy has been expansionary, it has exerted downward pressure on the value of the dollar and thus made U.S. exports more attractive abroad. Some of our trading partners have criticized us for this. Perhaps, then, we should not be so quick to seek tariffs in response to “currency manipulation.”
Nor should we be quick to take any action against the alleged danger of “predatory pricing.” This bogeyman has an extensive history in both trade and antitrust policy — a company or country allegedly sells below cost to bankrupt the competition and then jacks up prices on customers who now have no alternative — but actual examples of this strategy’s working have been rarer than clear skies over Beijing. Economists have had a far harder time finding them than explaining the formidable obstacles to the success of such a strategy, including the immense costs of its first phases.
This is as good a time as any to revisit the case that an earlier generation of trade alarmists made against Japan. Cass is aware of the fact that nearly everything he says about China was said about Japan in the 1980s: They were breaking the rules of the game, taking advantage of our free-trading naïveté, and we had to take drastic action. Predatory pricing was a major preoccupation of the alarmists then: Supposedly Japanese television makers were waiting for the day when they could bleed U.S. consumers dry.
This history should but does not embarrass Cass. He even suggests that the case against Japan was largely correct and should have been heeded. Yet the promised reckoning we were supposed to suffer never happened — television sets have just been getting cheaper and better, as you may have noticed — and Japan has hardly amassed fearsome economic power since the 1980s. Its economy has instead limped along for many years.
In addition to overstating the dangers of current trade patterns with China, Cass overstates the likelihood that the strategy he recommends will work. In part that is because he again exaggerates the importance of trade policy. He wants us at least to make a credible threat to impose massive tariffs, for example, but even if we levied those tariffs, it is not a given that we would significantly shrink the long-term bilateral deficit. Higher tariffs would likely cause the dollar to appreciate, which would tend to increase that deficit. American companies would find it more attractive to sell in our protected home market than to try their luck abroad, and this would restrain export growth. (Moreover, any fall in imports from China would partly be made up by increased imports from other countries, thus dampening any effect on our overall trade deficit.) Even in the short run, it is far from clear that Cass’s strategy would be anywhere near as effective as he implies.
Achieving Cass’s goals would also have some negative consequences. In the very-best-case scenario, the United States wouldn’t have to impose a tariff and China would stop its objectionable behavior. In that event, U.S. consumers would be paying higher prices for imported consumer goods, and some U.S. firms would have to pay higher prices for imported supplies to use in their own production of goods and services. While it may be in the interest of some U.S. workers and firms to see China’s trade practices stopped, it is not in the nation’s interest as a whole to increase the price of imports. In addition, over the long run, movements in the exchange rate could make it harder for other firms to export to China, even in this scenario, which would reduce employment in firms that depend on exports. Are those jobs somehow less worthy of protection?
There are other costs he ignores. Cass wants China to buy fewer U.S. bonds. Fewer Chinese exports to us and more Chinese imports from us would indeed leave China with fewer dollars to buy our bonds. While there are some valid reasons to be concerned about Chinese bond holdings, a decline in their bond purchases might force us to pay higher interest rates on those bonds. In today’s economy we shouldn’t put upward pressure on those rates. (Of course, in the event of an aggressive trade war, there will likely be a “flight to safety,” which would lower rates, as happened during the global slump of 2008; but this is hardly a happy precedent.)
It is also likely that closing the bilateral trade deficit in this manner would lower investment spending in the United States over the long term. Again, this conclusion follows from accounting identities. Reduced investment would be bad for long-run economic growth, and would lower the wages earned by tomorrow’s workers.
And, of course, less trade with China means less of the standard good that comes from trade between any two parties, be they nations or firms or individuals. In this case, the good is the ability of the U.S. firms to specialize in the production of certain goods and services and to enjoy the fruits of economies of scale. Almost all of these costs would be higher if we actually raised tariffs rather than just threatening to raise them.
We have not, so far, made any mention of the possibility of Chinese retaliation against U.S. exporters. Such retaliation is of course a prospect that a sober-minded U.S. government would weigh in its deliberations, rather than dismiss with bluster about “appeasement.” Cass reassures us that retaliation would be unlikely. Indeed, we would not even have to take the aggressive steps he outlines, because the credible threat of them would induce better Chinese behavior. He therefore never weighs the costs of following through on our threats. He is recommending a strategy of bluffing, in other words, without making contingency plans for the event that the bluff is called. (If trade policy really is war, we need another general.)
To Cass’s credit, he acknowledges that Chinese retaliation against U.S. firms would leave them at a disadvantage against other countries’ firms when trying to compete in China. His solution: “Where nations act in concert, they can do so without fearing such a consequence.” This is not really a solution, though, so much as an act of faith. How to bring about this international coordination for a course of action that no major developed-world government currently wishes to take — and that all of them have good reasons to refrain from taking, there being competent economists advising each of them — is left completely unclear.
Cass never reckons with any of the costs or risks of the policies he recommends. Disrupting the most geopolitically important bilateral economic relationship in the world is no big deal because we are, allegedly, already in a trade war. A brief mention that tariffs might cause “some economic disruption” is all Cass is willing to say.
This is not the advice of a realist urging skepticism about a textbook model. It is advice that wishes away any feature of the real world that is inconvenient to the argument.
So Cass’s strategy seems unlikely to yield the results he seeks. Then again, what he seeks is not entirely clear. He says the World Trade Organization is useless because it only authorizes retaliation against unfair trade practices, which reminds him of kindergarten — but retaliation against unfair trade practices is what his article advocates. He faults China for restricting American companies’ activities in China — and then complains that those companies reinvest too much of their money there, and says they should not be allowed to sell their products there at the prices they think most advantageous.
None of this has much to do with Cass’s ultimate stated goal of freer commerce. A better approach would be to recognize that many of our economic problems are home-grown, and to tackle them. If we want to make the United States a more attractive destination for investment, we should reform our tax laws accordingly. We should save more and rein in federal entitlement spending, for a lot of reasons, and if we did, we would borrow less from China and shrink the trade deficit.
Our larger posture toward China should be one free of illusions, both about the character of the Chinese regime — it is a tyranny with interests contrary to ours — and about our ability to change its character with the flick of a wrist. We should intelligently use the tools at our disposal to promote our interests in the development of a China that is peaceful toward its neighbors, respectful of human rights, cooperative in international fora, and open in trade and investment. Some of the specific steps Cass outlines might even, under some circumstances, be appropriate.
A sensible policy would, however, involve understanding that our wishes for China cannot easily be achieved; distinguishing between commerce and warfare; rejecting alarmism about the trade deficit; and resisting the impulse to take counterproductive actions in the name of doing something. A trade war is not a war, but neither one should be started recklessly and without a strategy.
– Mr. Ponnuru is a senior editor of National Review. Mr. Strain is a resident scholar at the American Enterprise Institute.