News & Politics

Trump’s Trade War with China Will Cause an Economic Catastrophe — Here’s a Better Solution

There’s a better solution than tariffs and trade wars.

Photo Credit: repmobrooks / Flickr

With the announcement by President Trump that the U.S. would start the process of imposing 10 percent tariffs on an additional $200 billion of Chinese imports in the next few months, it is safe to say that the U.S.-China trade war has definitively moved past the phony war phase. This action goes well beyond placating some important rust belt/swing-state constituencies and reflects the president’s deeply held belief that trade is a zero-sum game in which the U.S. has been persistently played for patsies over the last several decades, especially by Beijing (although, as last month’s G7 summit demonstrated, neither the EU, nor Canada, is exempt from this animus either). The cumulative actions undertaken by the president now account for almost 7 percent of total global trade, according to the economist George Magnus, reflecting the magnitude of Trump’s efforts.

If Trump is actually hoping that tariffs will enhance the possibility of boosting America’s export markets, he’s in for disappointment and a good deal of anger from the very economic sectors he might have expected to champion him. Modern global supply networks have been established on the assumption that globalized free trade and capital mobility were permanent realities. The so-called “Washington Consensus” has assumed globalization as an irreversible process to such a degree that U.S. companies are utterly reliant on global supply chains.

So what is the solution? Perhaps that might come via the imposition of local content requirements as opposed to a haphazard reliance on tariffs, which is to say that when a foreign company manufactures a product in a country, a certain proportion of those materials and parts should be made in that country domestically rather than imported. This is not unusual. In fact, China makes use of this practice very liberally, and insists that a minimum level of local content is required, when giving foreign companies the right to manufacture in a particular place. And if this requirement is mandated going forward, it may well arrest the ongoing “de-skilling” of the American labor force (because it slows the outsourcing of manufacturing), as well as curbing labor arbitrage (to be fair, labor arbitrage is less of a problem when free trade pacts are done between countries/regional blocs of comparable living standards, such as the recently concluded EU-Japan trade pact). So it’s potentially a win-win for American workers and businesses.

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In a previous article, I explored the possibility of U.S. consumers being impacted in the event of a supply disruption engineered by Beijing using its dominant production in either rare earths or ascorbic acid, which is widely used in food production to improve quality and stability. Given the relatively self-sufficient nature of the American economy, the U.S. can probably withstand this kind of potential trade shock better than most countries, and ultimately can crank up production domestically to mitigate any short-term threat to supplies from China. More problematic has been the longstanding proclivity to outsource manufacturing rather than raw or refined materials, the long-term effects of which are more difficult to alleviate.

The U.S. will have to consider adopting policies to re-establish an “industrial ecosystem” (to coin a phrase used by political economist Seymour Melman) if it is to mitigate the threat posed by overseas supply disruptions, and counter the longstanding lament of U.S. manufacturers that they cannot find American workers with the right mix of domestic skills. The latter point is addressed in a Harvard Business Review study by Professors Gary Pisano and Willy Shih:

“Tool and die makers, maintenance technicians, operators capable of working with highly sophisticated computer-controlled equipment, skilled welders, and even production engineers are in short supply.

“The reasons for such shortages are easy to understand. As manufacturing plants closed or scaled back, many people in those occupations moved on to other things or retired. Seeing fewer job prospects down the road, young people opted for other careers. And many community and vocational schools, starved of students, scaled back their technical programs.”

The authors rightly note that the complaint of U.S. manufacturers that they do not have enough skilled workers confuses cause and effect. But the problem is even more serious than suggested by Pisano and Shih: Through massive outsourcing of the supply chain, the U.S. has empowered countries such as China with far greater leverage on trade matters. Instead of responding with a tit-for-tat tariff, the Chinese premier now can simply threaten to cut off Apple, or IBM, or any number of U.S. multinationals from critical parts.

We cannot entangle our supply chain so thoroughly with another country that their companies can ignore U.S. law and get away with it, because of a credible threat to the supply chain. No one country should have that power—however, the reality is that we live in a world where an automobile is made of parts 80 percent supplied by outside producers, from sometimes dozens of countries. This process can be highly efficient from a cost perspective in a global market, but in a world filled with tariffs, it can be mitigated by enforcing indigenization everywhere in the high value added supply chains to which all economies aspire.

The imposition of local content rules would end the possibility of any country cornering the market, thus reducing incentives for currency manipulation or subsidies. Done right, local content requirements would destroy the business models of chronic surplus countries like Germany, Japan and China. Their firms could invest in transplanted companies abroad, but the transplants would be de facto local factories, rather than designed for re-export back into the American market (in contrast to the current trade regime where—per a New York Times report—“Dell, Hewlett-Packard and Samsung have all flocked to China to lower their production costs, bolster their bottom lines and tap into the world’s largest consumer market”).

How to do this the right way? Let’s say there are four major markets that are also major producers: North America, Europe, East Asia and South Asia. Most trade is done within the same industrial sectors generally, as opposed to distinct and separate industries. They agree that each region can reserve 25 percent of its market for locally produced goods (or more realistically, components of final assembly goods). The other three blocs can compete for the other three-quarters of the local bloc market. If the locally produced share falls below one-fourth of the local bloc market, it can impose quotas while helping the local producers regain their share, preferably by improved productivity or business models.

Local content requirements are much more trade-friendly than tariffs since policy-makers are protecting a fraction of the market, not the full 100 percent. Once you eliminate the incentive to run merchandise trade surpluses, you don’t need all the elaborate schemes for deterring or sterilizing them. And it mitigates the need to resort to tariffs which, in any case, create both winners and losers, without necessarily resolving the problems that the tariffs were designed to solve in the first place.

Part of the reason why there has been such a proclivity toward offshoring manufacturing is that manufacturing itself is viewed as a cost variability through the narrow prism of short-term profitability (beating the quarterly number has been an ongoing game on Wall Street, used to perfection by figures such as GE’s former CEO, Jack Welch). As a result, note Pisano and Shih, “executives… give short shrift to the impact that outsourcing or offshoring it may have on a company’s capacity to innovate. Indeed, most don’t consider manufacturing to be part of a company’s innovation system at all.”

The problem goes beyond that, as Seymour Melman noted in his book, Dynamic Factors in Industrial Productivity, where he makes the case that the unremitting focus on low-cost labor inhibits technological innovation and invariably pushes companies to global labor arbitrage. The basic idea was elaborated by one of Melman’s former researchers, the political economist Jon Rynn:

“[F]aced with high labor costs, firm managers will be more willing to mechanize, that is, use more machinery, and more sophisticated machinery, instead of using labor. By using more, better machinery, they increase labor productivity, which leads to higher wages, and they also stay at the cutting edge of technology.”

Retaining a degree of homegrown manufacturing also mitigates the production risks posed by divorcing product design and manufacturing (such as originally occurred with the Boeing 787 Dreamliner program, which was characterized by massive cost overruns and ongoing engineering problems).

Needless to say, these sorts of ideas are despised by the apostles of free trade, who have conveniently dismissed globalization’s losers as “negative externalities,” the “deplorables” who (as I have noted before) have been “displaced from their jobs by globalization, automation, and the shifting balance in manufacturing from the importance of the raw materials that go into products to that of the engineering expertise that designs them.” There is also the issue of WTO rules, which limit the degree to which local content rules can be deployed (generally okay for government procurement on infrastructure, but problematic beyond that). That might explain part of the public musing by Trump in regard to America’s future relationship with the WTO or observance of its rules. But the truth is that America’s workers have suffered major displacement in a long-running trade war, “one in which,” as David Dayen argues, “for decades, the United States never fired a shot on their behalf.”

Tariffs might not be the answer, but they reflect an increasingly desperate attempt to break the stranglehold on a system which increasingly focuses less on “free trade” per se and more on simply privileging oligarchs and entrenching the powerful multinational corporations at the expense of everybody else. An increasing focus on local content rules might represent a more effective response than tariffs of helping to re-establish more domestically oriented supply chains, and reversing the adverse impact of offshoring. It would also deter governments from seeking to monopolize particular industries, and deter firms from offshoring based on labor arbitrage. This eliminates bubbles driven by overinvestment (Asia) with profits recycled as consumption elsewhere, because governments, unable to deindustrialize their trading partners, have little incentive to overinvest in industry and dump the products to drive others out of business. And for its part, the private sector will invest only in response to actual or projected demand.

In any event, new proposals have to be found to arrest the ongoing erosion of the living standards of the middle and working classes, lest this trade war, like a real war, goes global.

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Marshall Auerback is a market analyst and commentator.