Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate on March 21st.
Donald Trump has postponed until April the supposed deadline for a conclusion to China-US trade negotiations. A good outcome for both sides would have China agree to better protect private property rights and to reduce the role of the state in its economy; the US agree to strengthen national saving and public investment; and both sides agree to reverse their recent tariff increases and the resulting shrinkage of international markets. Unfortunately this deal is not likely to happen.
What does the US want?
Trump fixates on the bilateral US merchandise trade deficit with China. Beijing could probably deliver on the verifiable – but worthless – step of reducing the bilateral balance by committing to buy more soybeans, natural gas and other commodities from the US. But this would have little or no effect on the overall trade balance, as the US would export less soybeans and natural gas to other trading partners. Congressional Democrats would point out that the gain was illusory. They would be right, which is just another illustration of the irrelevance of bilateral trade balances.
Overall trade balances are more meaningful. But as economists always explain, the overall trade balance is determined, not by trade policy, but by national saving and investment. That the deficits widened in 2018 was the predictable result of Trump’s $1.5 trillion corporate-targeted tax cut.
The US and other trading partners have more legitimate complaints against China when it comes to technical knowledge transfer and intellectual property rights. But the effective way to pursue such negotiations would have been in cooperation with allies, via such multilateral institutions as the WTO and the Trans Pacific Partnership. Trump has gone far out of his way to pursue the opposite of this cooperative multilateral approach, making progress difficult.
Asking China to reduce the role of the state
Deducing a coherent rationale for US trade policy is a challenge. But one could envision a theme in the demands that have been placed on China: pushing it to restructure its economy in the direction of a greater role for the market, shrinking the size of the state sector and lessening pervasive government control. Certainly this has been the tenor of US demands in previous administrations.
The interesting thing is that pro-market reforms, generally speaking, would tend to be in the interest of the Chinese economy. This is recognized by many economists, not just American or foreign, but Chinese as well. For that matter the plan to shift emphasis from the state sector to the private sector was enshrined in the Third Plenum of the 28th Party Congress in 2014. The program called for a reduction in the role of inefficient state-owned enterprises to allow more dynamic private firms more room to grow, among other things. The rhetoric has not been disavowed. (As recently as March 14, Premier Li Keqiang called for deregulation.) But little or no progress has been made on these reforms.
To the contrary, it has become clear from his actions that President Xi Jin Ping is not interested in reducing the size or role of the state, even in the gradual measured way of his predecessors. Inefficient state-owned firms continue to benefit from easier access to bank loans than the more dynamic private firms. Indeed Nicholas Lardy of the Petersen Institute for International Economics points out that Xi has rolled back market reforms. The Chinese President is said to be closer in spirit to Mao than to the intervening leaders. It is not clear whether Xi lacks appreciation for the potential economic advantages of free markets or whether he has decided he is willing to sacrifice some economic performance for the imperative of maintaining political control over Chinese society.
To say that reforms would be in China’s interest is not to say that they would not also benefit the US and other trading partners. The game is not in reality zero-sum.
A good example is government subsidies for heavy industry such as steel mills, particularly in the form of cheap loans from state-directed banks. This was one component of China’s fiscal expansion in response to the global recession of ten years ago. The counter-cyclical timing of the “Keynesian” stimulus was excellent; the resource-allocation of the spending was poor. The program left China with tremendous excess capacity in steel – bad for the efficiency of the economy, bad for foreign competitors (and bad for the environment, to boot). Subsidies to steel and other heavy industry are “exhibit A” in the argument for shrinking the footprint of the government, including local government.
Does the US want a market-determined exchange rate?
A different kind of example of free-market rhetoric concerns the history of US demands over the yuan. Trump, as candidate and as president, has attacked China for manipulating its exchange rate. The charge – which has been made by American politicians ever since 2003 – is that the Chinese authorities intervene in the foreign exchange market to keep their currency unfairly undervalued (by buying dollars and selling yuan, to dampen its appreciation). The US objective was to help its producers compete against low Chinese prices; but the campaign was justified in the name of allowing the foreign exchange market to work freely.
For 10 years, this position made sense. But in 2014, market forces changed direction. Since that year, China’s central bank has had to spend almost $1 trillion of foreign exchange reserves (easily a world record) in trying to resist the depreciation of its currency. If it had acceded to the demands of American politicians to let the market work, the yuan would have depreciated even more than it has.
Apparently keeping the value of the Chinese currency high is still a key US demand in the current negotiations. The Chinese authorities, for their part, have no desire to let the yuan fall freely. But after 5 years it has become apparent to all that the goal of stabilizing the exchange rate is inconsistent with the rhetoric of reducing government influence and letting the market work.
The precedent of the Japan-US Structural Impediments Initiative
As in so many other respects, the structural reform aspect of US negotiations with China is reminiscent of negotiations three decades ago with Japan. In June 1990, under the Structural Impediments Initiative (SII), the Japanese government agreed to a detailed set of structural policy reforms, requested by the US government under the administration of President George H.W. Bush. The background behind the initiative was Congressional anger at a large bilateral trade deficit with Japan. The objective of SII was to respond to the issue in ways that would be more fundamental and effective than tariffs. Japan, for example, agreed to tighten enforcement of competition laws, to loosen ties among its keiretsu (industrial groupings), to make it easier for large-scale retail chains to open stores, and to reduce the bias toward using land for rice farming.
At the same time, the US agreed to reforms on its side, designed for example to increase its rates of private and public saving, reduce the tax bias toward debt-financed homeownership, and strengthen investment in education and training. Such reforms would work to reduce the trade imbalance [particularly by narrowing the gap in the two countries’ national saving rates]. But it was noteworthy that the US asked Tokyo to do things that would improve the efficiency of the Japanese economy while Japan asked Washington to do things that would improve the efficiency of the US economy.
As it happened, the “Japan threat” began to melt away soon after the Structural Impediments Initiative, but not because of US or Japanese trade policy. A three-year Japanese financial bubble burst in 1990, and the economy has never quite recovered since. The rapid aging of Japanese population plays a large role. For one thing, aging reduced the national saving rate — as economists had predicted. In turn Japan’s trade balance fell as a share of GDP, helped by an appreciated yen. (Similarly, China’s trade surplus peaked in 2008, and subsequently fell, helped by an appreciated yuan.)
SII was a success, not because it eliminated the bilateral Japan-US trade balance, but because it made some modest steps toward mutually beneficial reforms at the same time that it avoided the political alternative of destructive tariffs and quotas. In theory, it could serve as a useful model for China-US negotiations, if they were in similarly competent hands. But the two countries’ leaders may not have as firm a grasp on economic principles as their predecessors. Xi Jin Ping appears to care only about maintaining the political control of the Chinese Communist Party, while Donald Trump appears to care only about… Donald Trump.
This post written by Jeffrey Frankel.