Why China-U.S. Trade Talks Are Destined to Fail

For the past several weeks, President Donald Trump’s trade negotiators have been meeting with their Chinese counterparts to develop a “draft framework” on trade liberalization between the U.S. and China. Even though no long-term framework was concluded, Trump has for the time being withdrawn the immediate threat of tariffs, according to U.S. Treasury Secretary Mnuchin, and both sides will continue talks over the summer.

But the longer-term issues that brought Beijing and Washington to the brink of a trade war remain; the can has effectively been kicked down the road. China has provided a face-saving promise to “significantly increase” purchases of U.S. farm and energy goods, without providing the specific numeric targets originally demanded by the president. And nobody should realistically expect a clear long-term resolution, largely because the talks involve two parties, with conflicting domestic agendas, neither of whom actually believes in free trade to begin with.

For Trump, trade appears to be a zero-sum game in which there has to be a winner and loser, rather than a win-win type of situation in which both sides benefit from the old free trade principle of “comparative advantage.”

By the same token, China has evinced little interest in opening up its market to domestic competition, even though Beijing essentially committed to doing so when it was admitted to the World Trade Organization (WTO) almost two decades ago. Instead, it has largely retained a mercantilist model, explicitly favoring import substitution and the growth of national champions; it has exploited the rules of the WTO to achieve a one-sided growth in export markets, to the detriment of its global trading partners.

Complicating this issue even further, from Beijing’s perspective, is the fact that in the process of achieving its quantum leap in economic development, the country has unleashed a historically unprecedented capital expenditure bubble, the disruption of which via U.S. trade protectionism could unleash severe economic dislocation and political instability. Accepting an arbitrary reduction in exports as demanded by the U.S. would therefore create big problems domestically for China, especially as its yet underdeveloped consumer sector is in no position yet to take up the baton of economic growth from the investment sector. All in all, then, conflicting national objectives create a recipe for inevitable failure.

It’s bound to be a defining feature of the relationship between the world’s two largest economic powers for decades to come, with significantly adverse implications for the global economy as a whole.

When China first joined the WTO, the prevailing assumption was that its economic development and corresponding regulatory regime would ultimately begin to converge with the free trade norms practiced by Western economies. The hope was that the promise of greater access to the export markets of the West would be accompanied by a gradual opening of China’s huge domestic market to the rest of the world. Instead, this has turned out to be a profoundly misconceived bet. Why? Because, as economist Brad Setser argues, even though historically “a big surge in investment typically is import intensive,” which would be of significant benefit to Beijing’s trade partners, China’s own economic expansion:

“[T]urned out not to be all that capital goods import intensive—in part because China has rigged its market for capital goods to favor domestic producers. China for example squeezed out imports as it expanded its high speed rail network, as it built out its wind turbine sector, and as it built up its solar capacity.”

In other words, the bargain didn’t hold. China got access to loads of new export markets for its products, but when it came time to expose its domestic market to foreign investors, the market was restricted, and the government imposed onerous joint-venture requirements, which meant sharing proprietary information about intellectual property and forced technology transfers. Matthew Klein has quantified the extent of this:

“Unlike most of the rest of the world, Chinese demand for foreign goods and services has collapsed relative to the size of the Chinese economy since the mid-2000s. Foreign production satisfied 17.5% of China’s domestic needs in 2004. That share has since dropped below 13% because of declining demand for foreign-made products.”

In many instances, this protectionism was often accompanied by intellectual property theft, a phenomenon that is a red flag to Trump’s trade hawks, such as Peter Navarro. In aggregate, all of these trends have given rise to the idea of China as a trade cheat.

The WTO “bet” of 1995 also completely ignored historic precedent, since virtually no nation over the past 200 years has actually followed a free trade path to economic growth and prosperity, as Professor Robert Wade noted in the preface to his seminal work on the subject, Governing the Market:

“Almost all now-developed countries went through stages of industrial assistance policy before the capabilities of their firms reached the point where a policy of (more or less) free trade was declared to be in the national interest. Britain was protectionist when it was trying to catch up with Holland. Germany was protectionist when trying to catch up with Britain. The United States was protectionist when trying to catch up with Britain and Germany, right up to the end of the World War II. Japan was protectionist for most of the twentieth century up to the 1970s, Korea and Taiwan to the 1990s.”

China’s authorities have ample historic precedent to argue that they are simply charting a well-trod path common to virtually every other country as it moved from emerging to developed economy. By the same token, it was probably naive of Western policymakers to assume, in the face of all historical evidence to the contrary, that China would simply hand over the crown jewels of its own economy, particularly given Beijing’s long memories of the West’s own ugly imperialist history in China during the end of the 19th century. History without memory provides ample grounds for future conflict, as these trade talks exemplify.

In regard to the specific charge of intellectual property theft, here too Trump and his team are on shaky ground. As economic historian Charles Morris has pointed out, the Americans were the 19th-century trade cheat equivalents of their Chinese counterparts of the 21st century, liberally stealing IP and technology secrets from the economically dominant power of that period, Great Britain. So there is a little bit of the pot calling the kettle black in this charge.

Seemingly unaware of this historic irony, the truth is, Trump’s trade team is in fact uninterested in more free trade. In reality, it has approached the negotiations less with a view toward securing additional trade liberalization per se, more in the nature of securing numeric targets that would privilege specific U.S. industrial and agricultural interests. The president’s goal in these negotiations is to satisfy the interests of various export lobbies in the U.S., comprising both agricultural (soybeans, wheat, beef, tractors, harvesters) and industrial (cars, civil aviation, advanced robotics) interests, which explains why chief among his demands was an explicit numerical target to bring the bilateral surplus with the U.S. down by $200bn in two years. Unfortunately, these also happen to be areas that Beijing has explicitly targeted for future growth in its recently published “Made in China 2025” document, which undoubtedly will provide further fuel for trade conflicts going forward as it outlines an explicit import substitution policy that aims to create yet more domestic national champions in precisely those sectors hitherto dominated by America’s exporters.

Conflict is also likely to be exacerbated by the aggressive unilateralist tone embraced by the Trump administration in these negotiations. The president’s trade negotiators have neither promised to refrain from any further protectionist measures, nor given any indication that the U.S. market would retain or expand its current access for Chinese imports. The only concession came in the form of a curious tweet, in which Trump (to the apparent surprise of his negotiating team) seems to have instructed the Commerce Department to help bail out a bankrupt Chinese telecommunications company, ZTE (although this may be related to the upcoming talks with North Korea, given that ZTE was sanctioned for doing business in Pyongyang). Trump also demanded that China refrain from making complaints to the WTO in the event that the U.S. does impose further tariffs or restrictions on China’s trade. In the words of the Financial Times’s chief economics commentator, Martin Wolf: “No great sovereign power could accept such a humiliation.  For China, it would be a modern version of the ‘unequal treaties’ of the 19th century.”

Even if it were prepared to contemplate some arbitrary reduction in its bilateral trade surplus with the U.S. (as the Japanese did with Reagan and Clinton in the 1980s and 1990s), there are other factors, which preclude Beijing’s capacity to make such concessions. As one of China’s leading economists, Yu Yongding, has argued, “[T]he fixed-asset share of China’s GDP today exceeds 50%, while investment calculated as residual capital formation accounts for some 45% of GDP.” Therefore, the risks that China faces today is the product of a fixed investment to GDP ratio, the disruption of which (an inevitable by-product of Trump’s demands) would create unprecedented havoc in the Chinese domestic economy.

When global export markets were booming, China was able to muscle out global competitors with very little blowback because of benign global economic conditions. And Beijing’s overinvestment was masked to some degree by ever-increasing exports. In the era of Trump, that path is no longer open to China.  

In effect, China’s import substitution policy/mercantilism has been operative for a long time, well before the publication of its “Made in China, 2025” policy, where the authorities have adopted an explicit plan of import substitution in lieu of the free trade practices it promised to embrace when it joined the World Trade Organization. But here’s the paradox, noted by, among others, Dani Rodrik:  “Selective protection, credit subsidies, state-owned enterprises, domestic-content rules, and technology-transfer requirements have all played a role in making China the manufacturing powerhouse that it is.” So why on earth would China want to discard this winning formula now, as it seeks to leap into the next echelon of economic development? Just because Trump demands it? On the other hand, Trump and his economic nationalist trade warriors identify this effort by China as yet another zero-sum game, whereby Beijing’s continued economic prosperity will come at the expense of the U.S., and therefore one to be confronted by means both on the trade and—if necessary—military side.

How to resolve this impasse? China is a nation of over 1.5 billion people. Now that the country’s investment boom has created a 21st-century style infrastructure, why not solve the trade problem by shifting its economic growth strategy toward a consumption-based model, which would then allow its massive population to enjoy the fruits of its own labor? Martin Wolf, among others, has advocated precisely this strategy. History, however, tells us something else: namely, when investment booms go bust, they take down the consumers who work in the investment industries first, especially in a situation in which domestic producers are doing the lion’s share of the investment. The additional complicating factor in China is that the share of the consumer in its economy, relative to, say, the U.S. or EU, is small. In the U.S., for example, consumption routinely drives almost three-quarters of GDP; by contrast, the consumption (as Wolf notes) represents a paltry 40 percent of the Chinese economy. Additionally, social welfare provision in China is still relatively underdeveloped, so a substantial pool of domestic savings is required to safeguard the average Chinese family to deal with retirement and other matters of family support. And the smaller the share of the consumer in any economy, the harder it will be for it to seamlessly spend more to offset a contraction in investment expenditures.

It is this vulnerability that lies at the heart of China’s current strategy. Beijing’s goal is to drive capital investment into areas hitherto dominated by foreign countries and minimize the amounts going into speculation in assets, such as real estate or stocks. It is a fine needle to thread, because much of China’s economy is still a communist, state-directed economy, even as it incorporates increasing market elements. The economy’s very hybrid nature means that credit expansions that fund the growth of these new sectors can also lead to households going deeply into debt; this is because the free market segment of the economy affords wealthier households the opportunity to use vulnerable inflated assets (in stocks or real estate) as their collateral to borrow and speculate some more. Externally, it also means that China cannot and will not accede to the demands of the Trump administration.

At the same time, having invested so much political capital in highlighting his skills as a “dealmaker,” Trump can hardly back down (even though one can hardly imagine the president, if confronted with similar ultimatums from Beijing, readily acceding to these demands). This is especially the case, given that Trump himself is not a free trader by instinct. In that sense, ironically, he is very much like his Chinese counterparts. It is like two identical magnets repelling one another. Truly, this is a case of the unstoppable force colliding with an immovable object, not a particularly happy outcome for the global economy.

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