On Terms of Trade

After the fall of the Soviet Empire and the entry of China into the global trading system, a new idea was added to the canon of neoliberalism: that formerly communist economic systems could be transformed into liberal democracies by the attraction of rising living standards. Soon thereafter, however, the growing industrial dominance of mercantilist China disrupted the political and economic calculus that a liberal, rule-based trading regime would produce balanced growth among faithful practitioners and that the U.S. would prosper by dominating cutting edge technologies in the modern economy. China’s export-oriented economic model decisively undermined Western industrial sectors starting with metals and electronics and later proceeding into higher-technology industries such as telecommunications, high-speed railroads, and automobiles. Meanwhile, the World Trade Organization (WTO), the centerpiece of this liberal, rules-based trading regime, proved ineffective in combatting the blatant disregard of its rules by its founders in transatlantic economies, and even less so by mercantilist regimes.

International trade growth fostered an unprecedented rise in global prosperity in the post-1945 period. But in recent years it has encouraged the prolonged atrophy of American industrial capacity and an erosion of domestic supply chains. The United States has only just begun to wake up to the consequences of this historic trend. Over 8 million American manufacturing jobs were lost after 1979 as supply chains moved overseas and U.S. manufacturers replaced workers with capital to meet low-cost foreign competition. The social impact of deindustrialization in the U.S. was perhaps the final blow as pathologies linked to the loss of blue-collar jobs engendered a political backlash against the postwar trading system. In 2020, the COVID-19 pandemic and attendant interruptions of key supply chains have underscored the problems of interdependence and the political reality of nationalist responses to them.

Trade policy alone will not solve the problems caused by vulnerable supply chains and the loss of industrial jobs, but it will be essential to any effective agenda addressing them. A different set of fundamental principles will help reverse these trends and bolster incentives to produce goods—especially high-technology goods and related services—in the United States. 

Three Principles of Trade

The principles proposed here are not new, but they require a new emphasis if trade policy is to be effective in a world economy much different than those in which the General Agreement on Tariffs and Trade (GATT, 1948) and the WTO (1995) were conceived. They are: reciprocity, national security, and democratic oversight.

The principle of reciprocity is simple in theory but complex in practice. Adam Smith has too easily been pigeonholed as a proponent of the unrestricted flow of goods, knowledge, and people across borders to maximize efficiency. But he also admitted to its limits: “…it may be a matter of deliberation how far it is proper to continue the free importation of certain foreign goods…when some foreign nation restricts by high duties or prohibitions the importation of some of our manufactures into their country.”¹Quoted in Jeffrey Peters, “Father of Capitalism Embraced the Use of Tariffs,” The News and Times (March 2, 2018). It is not only China that violates this principle systematically, but many proponents of open trade as well. Agricultural goods are largely exempted from trade liberalization. India restricts imports of most high-technology goods and services, and maintains bound tariffs averaging 49%. All nations protect their telecommunications and airline sectors.

The way to think about reciprocity is straightforward: a real balance of rights and protections between trading partners that is mutually beneficial. A simple metric of trade flows does not convey the real impact of reciprocity. At a minimum, reciprocity implies equal access to market opportunities. When China systematically subsidizes exporters and appropriates intellectual property while restricting access to its markets, or Europe applies higher tariffs on autos and blocks imports of genetically modified products while offering no offsetting measures, or India refuses to honor pharmaceutical patents, reciprocity is undermined. But redress is difficult to achieve under existing WTO rules and procedures.

The second principle is that national security imperatives are crucial to any trade and related investment policy. This idea has long been recognized, including by Adam Smith,²Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, Vl II (London: W. Strahan and Company, 1778). but it is especially important in an age in which commercial technologies are increasingly hard to separate from those important to national defense products and systems. The security of telecommunications and electric power infrastructure are part and parcel of national security. Many also argue that medical products and services should be considered vital to national security, a concern obviously brought into sharp relief by the present pandemic.³Scott Atlas and H. R. McMaster, “Relying on Foreign Drugs Is Dangerous,” Wall Street Journal (April 28, 2020). Purist supporters of a rules-based trade order would argue that the WTO can adjudicate differences of interpretation of what constitutes a legitimate security sector (famously steel, for instance). U.S. Trade Representative Robert Lighthizer, however, is right to insist that each nation has an absolute right to determine its own security imperatives and meet them with domestic resources.⁴See “Hearing on ‘Approaching 25: The Road Ahead for the WTO; Questions for the Record for Ambassador Robert Lighthizer, USTR,” U.S. Senate Committee on Finance (March 12, 2019).

Related to the second principle is the third: democratic oversight of trade policy by sovereign states must be restored. There are two strands to this concept: The abstract rules of economic efficiency should not be the only consideration for setting economic policy, and the role of technical experts must be balanced by democratic oversight.⁵Oren Cass, “Putting dynamism in Its Place,” National Affairs (Spring 2020). In practical terms, what this implies is that democratic (or republican) institutions such as the Congress can surely decide whether considerations, such as the resilience of medical or certain high-technology supply chains, should override the imperatives of lower-cost production. In an era of unprecedented prosperity, a nation could choose to pay more for domestically produced medicines or supercomputers than those imported from an adversary or an unreliable supplier.

Yet the tension between technocratic management and democratic oversight that is ubiquitous in the 21^st century has roots that extend back to the Bretton Woods trade order and a deep mistrust of populist rule and ill-informed politicians emerging from the chaos of the 1919-1945 period.⁶Even the stalwarts of the London School of Economics preferred rules-based order enforced by technocrats. As one historian argues:” Hayek, for instance, feared … ‘unlimited’ (or what Von Mises called ’omnipotent’) democracy as always leading to totalitarianism out of a logic of capture.” See Quinn Slobodian: Globalists: The End of Empire and the Birth of Neoliberalism (Boston, Harvard University Press, 2018). The GATT and especially its successor, the WTO, were always conceived as supranational in character, with rules that take precedence over domestic law. Its quasi-judicial procedures often bypass member negotiations to make new law or to overturn the laws of sovereign nations. But over time, the WTO has proved incapable of enforcing existing rules and addressing problems such as forced technology transfer and state subsidization of industry.⁷Thomas J. Duesterberg, “Now is a Good Time to Reform the WTO,” Wall Street Journal (December 1, 2019).

Reforming the WTO to Rebalance Production Incentives

There are multiple paths by which the principles outlined above could induce firms to return supply chains to the U.S., largely by weakening the opportunities for mercantilist foreign competitors and strengthening the calculus in favor of domestic production. For instance, the U.S. has already leveled tariffs against China for violation of existing WTO rules as well as national security concerns associated with the dual use of certain products or their acquisition by the People’s Liberation Army (PLA). Because the U.S. does not enjoy reciprocal access to the Chinese market and faces systematic dumping of subsidized products by Chinese firms, the Trump administration has imposed broad restrictions on Chinese exports. It has also increased scrutiny of Chinese purchases of firms in the U.S., a strategy also used by allies in Europe and Japan, thus diminishing Chinese access to the technologies it needs to compete with firms in advanced economies.

Such actions damage the Chinese economic model as well as the balance of incentives to produce and move supply chains to the Middle Kingdom. They also weaken the economies of scale and ease of access to advanced technologies for China. In 2016 more than 75% of Chinese exports of advanced-technology goods to the U.S. were made by wholly foreign-owned or joint-venture companies. During the same year, the domestic content of all advanced-technology exports from China was less than 50%.⁸Mary E. Lovely and Yang Liang, “Trump Tariffs Primarily Hit Multinational Supply Chains, Harm US Technology Competitiveness,” in US–China Economic Relations: From Conflict to Solutions, eds. Ha Jiming and Adam Posen, Peterson Institute for International Economics (PIIE) (2018). Many analysts have shown that China’s ability to innovate still depends on access to American firms and research institutions.⁹John Lee, “Decoupling the US Economy from China after Covid-19,” Hudson Institute (2020)

Unfortunately, the WTO has shown itself ill-equipped to maintain an effective system of international trade, with much of the action now confined to unaccountable WTO judges arbitrating disputes and interpreting existing rules.¹⁰Thomas J. Duesterberg, “The Importance of WTO Reform from a Transatlantic Perspective,” Hudson Institute (2020). Reform of the WTO itself now requires unanimity of its more than 160 members, which effectively blocks any attempt to create new rules for the modern economy, vigorously enforce its existing rules, effectively sanction mercantilist actors, reverse long-standing asymmetries in its rules, or overrule its techno-bureaucratic decisions. These are underlying structural challenges of an organization that was designed for a global economy that no longer exists.

The United States should address these problems by working with allies to reform the WTO, not abandon it. The recent proposal by Senator Josh Hawley (R-MO) to abolish the WTO is not a good idea for several simple reasons.¹¹Josh Hawley, “The W.T.O. should be Abolished,” New York Times (May 5, 2020). The U.S. alone cannot abolish the institution. Withdrawing would only further alienate allies such as Japan, the United Kingdom, and other European nations, who could be helpful in achieving better rules to combat the China challenge. The U.S. has had some success in convincing allies to join its WTO complaint against Chinese intellectual property theft and also won a landmark case in the WTO to curb state subsidies to Airbus Industries. If the United States is to reverse the damage to domestic supply chains built up over the last 70 years, it should pair reform of the institution with vigorous use of U.S. trade law and regional trade pacts.

Modernizing the WTO to meet the challenges of China and others to a market-based and reciprocally balanced trade system can only be achieved if the organization’s unanimity rule gives way to majoritarian decision-making reflective of member-party priorities.¹²Thomas J. Duesterberg, “The Importance of WTO Reform from a Transatlantic Perspective,” Hudson Institute (2020). So long as a unanimity rule governs, the institutional paralysis that has reigned since 1995 will continue empowering technical experts to make the relevant policy choices in the interstices of existing rules. Reform of the reform process itself must be the top priority.

In a WTO prepared to make substantive changes, the reform agenda should focus first on establishing better rules to limit the role of state subsidies and the power of state-owned enterprises. Subsidies underpin the Chinese march to technical parity and trade advantage encapsulated in the Made in China 2025 program.¹³John Lee, “Ambition and Overreach: Countering One Belt and One Road and Beijing’s plans to dominate Global Innovation,” Hudson Institute (2020).

Updating WTO rules is also important in seeking reciprocal access to more open economies that enjoy advantages relative to the United States. Long-embedded rules often favor European nations at the United States’ expense. For instance, the WTO tolerates higher auto tariffs for U.S. exports as well as rebates of high European value-added taxes for its exports while refusing to accept U.S. efforts to adopt reciprocal border adjustable taxes.¹⁴Ike Brannon and Thomas J. Duesterberg, “Tax Reform and the Republican Manufacturing and Growth Agendas,” Tax Notes (July 10, 2017); Gary Hufbauer and Lucy Lu, “Border Tax Adjustments: Assessing Risks and Rewards,” Peterson Institute for International Economics (PIIE) Policy Brief 17 (2017). Curbing the overreach of the WTO’s Dispute Settlement Body and allowing more scope in the WTO for “plurilateral” agreements negotiated by coalitions representing a supermajority of trade in a given sector would help to overcome longstanding problems dating to the early years of the GATT as well as new problems associated with the rise of modern mercantilist states.

Finding a solution in the WTO would be ideal, but absent this, the United States should pursue other policies to combat China’s strategy—either with a coalition of the willing or, if necessary, by leading on its own. Coordination with longstanding allies in the “Five Eyes” group would be a good place to start.¹⁵J. Rogers, A. Foxall, M. Henderson, and S. ArQuinn Slobodian, Globalists: The End of Empire and the Birth of Neoliberalism (Boston, Harvard University Press, 2018); James Rogers et al., “Breaking the China Supply Chain: How the ‘Five Eyes’ Can Decouple from the China Supply Chain,” Henry Jackson Society (May 14, 2020). Given the increased tensions with, and intransigence of, China, the United States should also reconsider its decision to pull out of the Trans-Pacific Partnership Agreement. Stronger rules of origin, however, must be incorporated into that agreement.

The example of Huawei is instructive to crafting an overall approach to reform of U.S. and WTO policies. In Huawei, China has employed state support of as much as $70 billion and technology theft to build a low-priced and competent national champion that undermines the ability of other firms to achieve profitability in global markets.¹⁶See Robert Spalding, “Data Security in a 5G World,” National Bureau of Economic Research (NBER) (March 16, 2020). The United States no longer has an integrated equipment maker, and the two European competitors, Nokia and Ericsson, struggle to remain financially sound enough to compete and invest in fresh technology. A U.S. policy toward Huawei, based on the three principles outlined above, would deprive the Chinese national champion of multiple advantages and give domestic and allied firms more time to find economically viable alternatives.¹⁷Thomas J. Duesterberg, “There is a Better Alternative than Huawei,” Wall Street Journal (February 5, 2020).

Placing trade restrictions, including export restrictions, on China and other nations certainly has costs. The American semiconductor industry, for instance, relies on China for 23% of its exports and controls almost half of all global production of this key enabling technology. The profitability of world-leading American firms allows them to devote 20% or more of their sales to research and to keep ahead of their subsidized Chinese competitors. Jeopardizing this model by risking access to the world’s largest semiconductor market, if China were to retaliate against U.S. sanctions, could endanger a vital area of American technological leadership.¹⁸Antonio Vara and Raj Varadarajon, “How Restrictions to Trade with China Could End US Leadership in Semiconductors,” Boston Consulting Group (March 9, 2020). On the other hand, U.S. restrictions have incentivized Taiwan Semiconductor Manufacturing Company (TSMC), the world’s largest fabricator of semiconductor chips, to locate a $12 billion plant in the United States, where the leading creators of new designs are already domiciled. The extensive supply chains for large fabrication plants could follow in TSMC’s steps.¹⁹Bob Davis et al., “Taiwan Firm to Build Chip Factory in U.S.,” Wall Street Journal (May 15, 2020).

One can be more confident that the appropriate tradeoffs for trade actions will be balanced when they are made by some democratic process rather than the impersonal logic of economic efficiency narrowly defined as that which produces the lowest cost to consumers, or by technical experts interpreting rules adopted fifty years ago.