Mutual Disadvantage

China today holds roughly double the U.S. market share of global manufacturing, has entrenched itself at critical points in U.S. supply chains, and outcompetes U.S. firms in numerous technological sectors the United States once pioneered and dominated. American policymakers now widely recognize that something went seriously wrong in our relationship with China, and that the Chinese Communist Party has outplayed the United States in its bid for technological and industrial strength. Most now recognize this competition has not been “fair” by standard market definitions, but some also believe—or fear—that China’s massive industrial investments at the expense of workers and households has been successful because it is simply a more effective strategy.

China’s strategy has produced significant short-term gains, which are reflected in China’s current industrial dominance. But those seeking to bring about an industrial and technological resurgence in the United States must also acknowledge its evident costs and weaknesses. China’s strategy now appears increasingly unsustainable as China faces declining productivity, mounting debt, and growing international pushback—especially from the United States, which has (belatedly) realized China’s strategy only works as long as American trade policy allows it to.

Those who excuse or sympathize with China’s model often echo the reasoning of free trade advocates, who assume that trade imbalances reflect differences in “comparative advantage” and that greater market share signals greater efficiency (and is therefore “earned” in a sense). But this view rests on two flawed assumptions about the relationship between production, investment, and labor under current market conditions. First, free trade advocates tend to assume that investment in foreign markets is driven by the same return-seeking motives found in American markets. Second, they assume foreign workers and households have the same bargaining power as American labor (which already faces its own limitations). 

Reflecting even briefly on China’s economy confounds these assumptions. In reality, today’s global “free trade” model promotes neither efficient investment nor fair wages, ultimately to the detriment of long-term global growth and stability. Put simply, China’s wage suppression strategy, still exploited or conveniently ignored by some in the United States, is unsustainable for both trading partners and their workers in the long-term. Recognizing the distortive and unsustainable nature of China’s economic regime, and the inadequacy of “comparative advantage” as an explanation for the imbalanced U.S.-China trade relationship, policymakers cannot rely on technological innovation alone to outcompete China. A productivity-driven approach to economic growth will instead need to integrate balanced trade principles that eliminate U.S. reliance on China and countries with similar policies, meeting more domestic demand with domestic supply. This will benefit U.S. workers and the broader economy by increasing wages and investment, which will in turn strengthen demand, lower pressure on government budgets, and fuel productivity growth.

Capital vs. Labor: When Tension Becomes Tradeoff

At the firm level, business owners must consistently weigh the costs and benefits of increasing wages and making investments that will increase the overall productivity of the enterprise. Ideally, owners seek to do both in a way that is mutually reinforcing. Wage increases and bonuses are frequently used to retain employees and incentivize greater work performance; the introduction of new tools and methods can increase labor’s productivity. Investments in new equipment and workforce training should result in wage increases as firms increase output and profits. When aiming to increase both productivity and wages, capital and labor can work symbiotically to improve the overall competitiveness of the firm, benefiting both its owners and workers.

But there are also plenty of scenarios where increasing wages or investment can harm a firm. If wages rise above the real productivity of a workforce, a business will become less competitive and its profits will suffer, resulting in less capital to invest and utilize for business growth. If a firm’s investments cannot be deployed with the workforce at hand or result in production capacity that exceeds market demand for the firm’s goods, profits will not meet the investment costs and additional cuts to wages become more likely. Firms are not countries, but the analogy can help clarify how investment and labor function in today’s markets. Unfortunately, under the “free trade” paradigm of the last thirty years, the U.S. and Chinese economies are better described by this latter scenario.

Examining the U.S. and Chinese economies on a macro level, one finds significant disparities in what comprises each nation’s gross domestic product (GDP). In China, investment accounts for over 40% of GDP, compared to 18% in the United States. As economist Michael Pettis has pointed out, this makes China a huge outlier: the global average is around 25% and the economies with the next highest investment rates average only 30-34% of GDP. 

In contrast, household consumption accounts for only 39% of China’s GDP, whereas it constitutes 68% of GDP in the United States. The global average is approximately 63%, while the G20 average is around 56%. This means China’s household consumption rate is significantly below average, while the U.S. rate is significantly above average. 

These disparities reflect the vastly different—but mutually unsustainable—economic strategies of China and the United States. China’s economy is driven by the central plans of its sole political party, which sets a growth target every year and invests as much as it needs to reach that target. Alongside annual growth targets, China also sets targets for global market share in certain advanced sectors (e.g., through its Made in China 2025, Strategic Emerging Industries, and Innovation-Driven Development Strategy initiatives). Ultimately, due to both capital requirements and a hyper-focus on global competitiveness (or export discipline), investment and industrial growth in China come at the expense of household consumption. Put another way, investment in China is indifferent to both profits and domestic demand.

In the United States, capital chases the highest (and generally quickest) returns, regardless of the location or long-term implications of the investment. Unlike China, which implements strict capital controls alongside its strategic investment goals, the United States allows capital to flow wherever it finds the best opportunity for yield or, in many cases, the best opportunity for shareholder return. This orients “investment” in the United States toward financial markets, which often provide higher returns at lower operational costs, while orienting investment away from direct business investment that yields more stable but moderate profits over a longer time horizon. In the case of public U.S. firms, returns are then often put toward stock buybacks, intangible assets, and simple cash holdings rather than investment in factories, equipment, technology, and workforce training. For private firms, especially those exposed to private equity, returns are often achieved through cost-cutting, debt-loading, and financial engineering rather than innovating or generating new value. 

By favoring extractive financial investment over productive business investment, the U.S. system encourages offshoring to nations like China, who provide the kind of cheap labor and subsidized capital that allow for cost-cutting and the maximization of short-term profits. This boosts U.S. shareholder returns, but at the expense of U.S. workers and industrial capacity, weakening the long-term resilience of both U.S. firms and the wider U.S. economy.

As a result of these market conditions, the United States has seen its trade deficit skyrocket to nearly $1 trillion per year, while China runs a near $1 trillion trade surplus. The United States has also seen its share of global manufacturing plummet from 23% in 1990 to 16% today, while China’s share has risen from 3% to 32% over the same period. Until recently, this was tolerated because U.S. economic policy was narrowly focused on domestic demand, with few policymakers drawing any distinction between consumption and broader economic health. 

Both nations’ strategies—and the interdependent relationship between the two—have increasingly undermined both productive investment and labor while encouraging unsustainable levels of debt that will further undermine both nations in the future. To understand why, we must explore the investment and labor dynamics for each nation.

Predatory Investment

China’s economy is oriented toward production and market dominance, while the U.S. economy is oriented toward consumption, corporate profits, and shareholder returns. All of these are worthwhile pursuits, but they become unstable when divorced from one another. In China, investment in production aims to achieve global market share by limiting labor’s share of income. In the United States, investment prioritizes returns regardless of where production occurs, resulting in offshored jobs, declining industrial production, and stagnant wages. In both nations, the returns sought by these investments—market share and production capacity in China, shareholder returns and growth in the United States—start to reach diminishing returns as labor receives less of the gains.

China supports its industries in several ways, including direct subsidies, land grants, research funding, infrastructure spending, a favorable tax structure, intellectual property theft, and favorable lending rates. In addition to providing baseline funding, these policies—the last in particular—favor much larger investment levels across China’s industrial sector.

Pettis has explained how China’s “repressed” financial market differs from that of the United States. Whereas U.S. monetary policy sets interest rates to promote maximum employment and stable prices, and generally applies across business, household, and government sectors, China sets interest rates to favor capital investment and affect households and businesses differently. Unlike the range of investment options available to U.S. households (e.g., stocks, bonds, mutual funds, etc.), Chinese households are mainly limited to depositing their savings in bank accounts. This makes household investment returns (and ultimately wealth) largely dependent on interest rate policy.

Chinese firms must also rely on banks for most of their financing due to strict capital controls. To favor production, Chinese banks set interest rates artificially low, allowing businesses to borrow at a lower cost while lowering household returns on bank deposits lent to those businesses. As a result, households become net lenders while producers become net borrowers, with households making little on their savings. 

In theory, interest rates in an economy with limited and centralized investment vehicles should largely track GDP growth rates. But in the first two decades of the 21^st century, Chinese nominal GDP growth averaged around 14% while nominal interest rates averaged only 5.5%. This disparity produces a divergence in Chinese household savings and “national savings” rates, which generally track each other in the United States, as more savings accrue to industrial and government sectors at the expense of households.¹Michael Pettis has referred to this disparity as a “financial repression tax.”

China then exacerbates the disadvantage to households by using its national savings to purchase foreign currencies.²China’s central bank (PCOB) foreign reserves soared from less than $200 billion in 2000 to nearly $4 trillion in 2014, but have remained in the range of $3.0-3.3 trillion since 2016. Which PCOB reserves have leveled, Brad Setser argues that China has directed its state and policy banks to purchase additional reserves in order to manage the yuan’s exchange rate through methods that avoid detection by the IMF and U.S. Treasury. This increases the relative value of foreign currencies (which, like goods, increases with demand) while weakening China’s currency. A weaker currency further advantages China’s industry, whose goods become more competitive in international markets, while disadvantaging Chinese households as their weaker currency can purchase fewer imports. This has the reverse effect on China’s trading partners, including the United States, whose producers are priced out of their own market by Chinese exports.

To put things in further perspective, China accounts for roughly 18% of global GDP, but constitutes nearly a third of global investment and manufacturing, and only 13% of global consumption. China sustains this divergence through massive trade imbalances. If a nation’s consumption rises more slowly than its GDP, which measures what a nation produces, that nation’s trading partners must absorb the excess production. This is borne out by the U.S.-China trade relationship, with the United States absorbing much of China’s excess production. Were the United States (and China’s other trade partners) to stop tolerating sustained deficits, China’s excess capacity would either go unpurchased or would have to be absorbed by its own population, meaning greater household consumption. 

For the first decade after China joined the World Trade Organization (WTO) and began enjoying most-favored-nation tariff levels from WTO members, China’s export-driven investment strategy yielded real gains, with overall productivity rising in tandem with growth. But starting in 2013, China’s total factor productivity has been negative, indicating that China’s investment is not resulting in gains to efficiency. Consequently, China must now overcome declines in productivity to meet its growth targets. Put another way, China now requires increasingly more capital and workers to achieve the same level of growth. According to economist Marvin Barth, “China’s economy now is so inefficient that it requires an extraordinary $11 of investment to create $1 of incremental output. Furthermore, these figures likely understate China’s inefficiency since they are based on reported Chinese GDP growth that probably is overstated.”

This has affected producers worldwide. When China subsidizes its industries beyond a level that increases productivity, it captures market share at the expense of more productive competitors in other economies. As those competitors go out of business or themselves shift production to lower-cost jurisdictions such as China (as discussed further below), productivity also falls in those markets as their industrial commons wither and workforce capabilities atrophy. In the United States, for example, despite productivity rising as a result of capital investment in the face of early competition from surging Chinese imports in the 2000s, labor productivity in the manufacturing sector has declined since 2010. 

Thus, while China saw rapid productivity gains in productivity in its earlier stages of industrial development, and while competition with China initially incentivized responsive capital investments and productivity gains in the United States, productivity gains flatlined in both nations as China’s predatory and inefficient investment began to take its toll on foreign competitors and Chinese labor. Recognizing they would not be able to out-invest their Chinese competitors, U.S. firms started looking for ways to cut costs rather than invest in the future, offshoring jobs and industrial capacity.³“Manufacturing Sector Productivity Collapse: A Tale of Two Technologies and One Giant Competitor,” Martin Fleming,The Productivity Institute, in process, 26 October 2023.

Competitive Advantage versus Labor Suppression

To justify the contemporary free trade regime, many appeal to David Ricardo’s theory of comparative advantage. The theory suggests that trading nations should focus on producing the goods they are most efficient at producing and rely on their trading partners to supply the other goods their economies demand. This creates larger efficiencies for both trading partners. Recognizing that efficiency has declined in both China and the United States over the past 15 years, it is evident that this theory does not apply to the current U.S.-China trade relationship. But this overlooks what those who invoke the theory really mean: the United States can extract more labor from China at a lower cost. 

Why isn’t “cheaper labor” itself a comparative advantage? Assuming equivalence ignores the importance of productivity to real advantage. For example, say a firm wanted to produce 1000 widgets with one week’s labor to sell at $10 each (with a potential total revenue of $10,000). In the United States, average weekly wages are around $1,225, while in China, they are around $320. Simplifying these numbers for our purposes, the firm could expect to hire roughly four Chinese workers for the same labor cost as one American worker. However, if Chinese workers only produce the widgets at one-quarter the speed and efficiency of American workers, and thus it takes a week for both sets of workers to produce the 1,000 widgets, there is no difference in labor cost relative to output. There would also likely be additional costs for transportation and remote management. Thus, wage levels tell us little about “comparative advantage” on their own.

This is evident in other historical U.S. trading relationships. While low-wage China has driven much of the recent decline in U.S. manufacturing’s market share, high-wage countries like Japan and Germany have greatly contributed as well. These nations’ firms are still able to draw market share because their productivity levels are high enough to maintain a price advantage despite paying workers comparable or higher wages than those in the United States.

In the long run, the mutual benefit of comparative advantage only occurs when wages align with productivity. When wages trail productivity, as in China, nations can capture market share in a way that benefits domestic producers at the expense of domestic workers, foreign producers, and foreign workers. But domestically, this will ultimately result in workers being unable to afford the goods they produce, creating a gap between domestic supply and demand. This gap can only be filled in three ways: 1) higher wages, 2) foreign demand (exports), or 3) debt (private or public). 

In continuing to suppress wages and household consumption, China must rely on the latter two options. Looking first at foreign demand, the free trade regime has enabled China to export its surplus production with minimal challenges, with the United States absorbing a significant portion. Rather than trading goods with China, the United States has instead purchased Chinese goods on credit and through asset transfers. After three decades of ballooning trade deficits, the United States now finds itself with a negative $24.6 trillion net foreign asset position, meaning foreign entities now own $24.6 trillion more in U.S. assets than Americans own in foreign assets. This has also resulted in a significantly higher U.S. debt-to-GDP ratio.⁴Public debt now stands at approximately 121% of GDP, while private debt stands at around 145% of GDP, resulting in a combined U.S. debt-to-GDP ratio of 266%.

China has also relied heavily on debt to support its investments. As productivity gains have slowed, requiring even greater investment levels to increase output, China’s debt-to-GDP ratio has swelled to an enormous 303%. China’s debt increased at twice the rate of its growth last year, and China accounts for over half of the entire global economy’s increased debt-to-GDP ratio since 2008. If China’s investments were productive, GDP should have risen faster than its debt levels. 

China not only disregards workers and households through its broader macroeconomic strategy, it also does so directly. Suppressed consumption in China often further results from child labor, forced labor, weak labor protections, and a social credit system that compels obedience and thrift. In some sectors, employees are expected to work 72 hours per week under a “996” schedule: 9:00 a.m to 9:00 p.m., six days a week. Many who migrate from rural areas to industrial centers face limited access to public benefits like education, health care, housing, and pensions under China’s “Hukou” household registration system. Workers interested in organizing are limited to a single, state-run union, and China’s leaders have recently cracked down on other organizing efforts in response to surging labor strikes.

More broadly, as Chinese workers’ wages continue to decline while output increases, their economic conditions deteriorate rather than improve, often in the form of higher unemployment, longer working hours, or lower household consumption.  What little Chinese workers have left to save is further siphoned by party officials seeking to prop up inefficient firms to capture more world market share. China’s efforts to suppress labor’s share of income are thus both systematic and direct.

China’s wage suppression has, of course, also affected U.S. workers, as firms unable to compete have closed shop, offshored, and eliminated jobs in the face of cut-rate Chinese prices. The effects have been well-documented in David Autor’s “China Shock” report and in further research by Anne Case and Angus Deaton on the surge in U.S. deaths of despair due to drugs, alcohol, and suicide, especially among working class Americans in those regions most affected by Chinese export competition. As Marvin Barth points out, per capita incomes in other emerging economies once competitive with China have also trailed off as China’s overinvestment has surged, indicating harm to economic welfare globally.

Restoring Balance: The Key to Mutually Advantageous Investment and Wages

Those who fear that China’s ascent means industrial dominance can best be achieved through worker repression should recognize the structural vulnerabilities in China’s economy. While China’s model of aggressive industrial subsidies and labor exploitation has delivered short-term gains, it increasingly shows signs of strain, including productivity decline, unsustainable debt, and growing international resistance. Ironically, though it embraces a near-opposite economic strategy, the United States faces similar challenges, largely due to its trade dynamics with China. By exposing its markets to China’s distortive economic policies, the United States has had to support household consumption as its industrial production and global market share have fallen, and has faced similar productivity declines, debt increases, and political blowback.

Recognizing the harm done to workers and overall economic health by the current imbalanced trade regime, U.S. policymakers must exert maximal pressure against China’s mercantilist investments and wage suppression. China’s economic strategy has negatively affected the quality of life, not just for Chinese workers, but for American workers and workers worldwide. It has resulted in slowed rather than accelerated productivity growth, forcing both the Chinese and U.S. governments to meet growth targets through deficit spending, increasing their debt-to-GDP ratios to unsustainable levels. Technological innovation will not overcome these structural challenges while the U.S. economy remains exposed to China’s and while wages remain artificially suppressed.

U.S. production should better align with U.S. demand. Closing the U.S. trade deficit will help ensure wages and investment rise to meet the challenges facing the U.S. economy in the years ahead, strengthening demand, increasing productivity, and lowering fiscal pressures. To restore economic conditions that are truly advantageous to both the United States and its trade partners, to capital and labor, and to productivity and living standards, tolerance for substantial and ever-widening trade imbalances must come to end. So, too, should the belief that durable industrial strength can be won at the expense of a nation’s workers.