A better alternative to Chinese tariffs

October 10, 2011

After jeopardizing the nation’s credit rating, the US Congress is hard at work again with a new idea to destroy nascent recovery, this time from the Democrat side of the aisle. The law I’m referring to is the proposed enactment of tariffs against Chinese goods in retaliation for their currency manipulation. This is one of those measures that sound good on paper and in economic models, but anyone with any sense of realpolitik or history will realize that it is doomed to fail.

In fact, this particular movie has already been played before in the form of the Plaza Accord of 1985. In that instance, major world powers including the US found themselves at the losing end of an industrial race with Japan, and forced Japan to sharply increase the value of the yen. Japan, being dependent on the US for defense, had no choice but to agree, and soon the value of the yen soared more than 50%. To everyone’s surprise, the US-Japan trade deficit did not budge at all. This is due to both political and structural economic reasons. Politically, the Japanese government and public took great pride in their multinational car companies, and did everything they could to maintain their competitiveness. The government used unofficial quotas to protect the domestic car market, while at the same time flooded their economy with low interest rate loans to leverage them up to compensate for the decreased profit margins. Structurally, the Japanese method of assembling cars, using robots instead of humans, was simply a better way of making cars, and one which the Detroit car companies could not imitate due to their unions. Simply put, Japanese cars were superior in initial build quality, lasted longer, and had better resale values. The monetary intervention did nothing at all, except fan an enormous asset bubble in Japan which eventually imploded.

The Chinese have advantages in 2 types of goods, labor-intensive cheap goods, and surprisingly, capital intensive goods as well. That they have an advantage in labor intensive goods is a natural economic fact stemming from the huge Chinese population, and should not be something that is targeted by US trade policy. They also have an advantage in capital intensive goods as well (such as solar panels, which as Bronte Capital has pointed out, is the economic equivalent of paying for all your fuel costs up front), because the Chinese government is willing to print money to support their domestic green energy companies at non-economic interest rates. Tariffs on Chinese goods of say 25% will most likely affect the labor-intensive goods most severely. Under the best case scenario, assuming that the Chinese do not engage in retaliatory tariffs or measures, there will be a shift of the production of labor intensive goods out of Chinese hands and into another country (say Vietnam), which arguably might be more willing to import American goods, and therefore the US trade deficit will decrease. But notice even in the best case scenario, the effect on US trade deficit will be indirect and slow, and there will likely be an intervening period of adjustment as production ramps up in non-Chinese countries. And most assuredly, the Chinese are not going to stand pat and watch while we export unemployment to their shores. At minimum, you can bet that the stocks of GM and F are going to quickly resume their previous trajectory towards zero. In the worst case scenario, the US becomes the scapegoat as the Chinese asset bubble pops, and the two countries becomes engaged in all-out economic or, god forbid, actual war.

As an alternative to tariffs, I propose a China-America Investment Act, which gives tax breaks and market access to Chinese and other foreign countries who site their capital-intensive industries factories on US soil. This makes natural economic sense, because when you make large capital-intensive pieces of equipment like cars, solar panels and wind turbines, it is often cheaper to manufacture the end product as close as possible to the target market. Politically, the Chinese government wants to transform their large companies into true multinationals with large foreign sales, and also want to stop printing Chinese yuan given that domestic inflation is already topping the charts. Instead, the Chinese can redeploy some US currency from their mountain of US Treasuries into more productive assets, and give the US economy a much needed demand boost. True, when the factories are up and running, they will employ minimal numbers of workers, but they will be quality jobs which pay good wages, and the US is never going to find an edge in labor-intensive industries anyway. And in the meantime, while the factories are getting built, many laid off construction workers will be able to find jobs again. I think this is a more viable win-win strategy. Certainly, this is better than flirting with economic war.


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