Last week during a Senate subcommittee hearing, U.S. Trade Representative Katherine Tai responded to a question from Senator Braun with the following discussion of trade between market-oriented and non-market-oriented economies:
But that's not the sum total of the challenge that we have, and I think that in your comments, you have started getting at the contours of the challenge that we have, which is a fundamental economic incompatibility between a very, very market based economy that we have here in the United States, and very strict division between the state and the private sector, and the Chinese economy, through which the Chinese state's interests and control and direction extend.
To your point about ... it would be great if we could have free trade, but you have to know who you're competing against, I always come back to the David Ricardo, Econ 101, where you have comparative advantage, and if you've got two islands, ... both of them producing bananas and making boats, but one of them has the conditions for producing bananas and the other one say has more engineers. The logic is that ... you should have one focus on making boats and the other one make bananas, they can trade and everybody is better off.
The problem is that that is not the world that we live in. And especially if you expand out that economic model, and you say it's not just two products that our economies make, but let's say there are 25 products that our economies make. And then you look at the theory of comparative advantage, and then you realize the advantages are not always natural. When you're working with another economy, even in the simplistic model, where that economy is a state capitalist model, that economy is going to be able to target and take over entire industries and create advantages that the market based economy doesn't have. That's the fundamental challenge that we have. And unless we start focusing on identifying that as the problem and thinking through how we address it, I think that we condemn ourselves to repeating cycles of experiences that we've had from steel and aluminum to solar.
The first point I want to make in response is that economic governance is not all or nothing, and none of the economies of WTO Members are purely state-run or purely market-oriented (hello Defense Production Act). Having said that, there are degrees of state involvement in the economy, and I think everyone would agree that China's economy has more state involvement that the U.S. economy. In those circumstances, how should U.S. policy-makers think about trade and competition with China? (Or how should New Zealand think about trading with Cuba, or various other examples).
Tai brings up the classic point about whether comparative advantage can be shaped by government intervention, and if it can, how does that affect trade relations. If one side is doing more intervention, should the other side react with trade restrictions or interventions of its own?
For what it's worth, while I agree that comparative advantage is a key concept to explain the benefits of free trade, I usually start in the other direction: Do tariffs and other forms of protectionism help an economy? Because if they don't, the fact that someone else is engaging in this behavior may not be a good reason for you to do it. I'm not going to try to resolve hundreds of years of debate about this in a couple sentences, but I'll just note my view that it's tough to make the case that protectionism works in theory, and in practice it's even more difficult. Yes, you can use these measures to shape your economy, and you can point to the winners from these policies. But if you take into account the losers as well, it seems to me you are almost certainly making yourself worse off on balance.
But that doesn't stop people from trying, and in the real world, as Tai points out, countries are faced with economic interventions from their trading partners that distort natural comparative advantage. Regardless of the economics of protectionism, or the economics of responding to someone else's protectionism, I see why this makes the politics of trade complicated, as the perception of "fairness" matters to many people. Even if they recognize the flaws of protectionism, the behavior of others can still feel unfair. Maybe that's because of a view that the high level of protectionism used by a particular government is an attempt to gain an advantage, even if it is doomed to failure in terms of its overall impact on the user's economy; or it could be a recognition that someone else's protectionism can cause harm to specific groups in your country, even if it is destined for overall failure.
Whatever the reason for concerns about the practices of trading partners, trade agreements can help with this problem. A trade agreement under which all parties make trade liberalization commitments can be politically important in terms of fostering a belief that the system is "fair" (in some sense of that word). If all parties agree to make liberalization commitments, no country is taking advantage of others.
I would argue that this is exactly what the WTO agreements try to do in general, and what China's WTO accession protocol tries to do in particular. They aim to create a sense of balance and fairness in the trading system.
The countries that negotiated with China on its accession were aware of China's non-market practices, and came up with rules that try to bring a sense of balance and fairness to those practices. For example, if someone is concerned about the behavior of Chinese state-owned enterprises, China's accession Working Party report (made binding by the Accession Protocol) addresses that issue:
46. The representative of China further confirmed that China would ensure that all state-owned and state-invested enterprises would make purchases and sales based solely on commercial considerations, e.g., price, quality, marketability and availability, and that the enterprises of other WTO Members would have an adequate opportunity to compete for sales to and purchases from these enterprises on non-discriminatory terms and conditions. In addition, the Government of China would not influence, directly or indirectly, commercial decisions on the part of state-owned or state-invested enterprises, including on the quantity, value or country of origin of any goods purchased or sold, except in a manner consistent with the WTO Agreement. The Working Party took note of these commitments.
But the WTO agreements are not self-enforcing. You need Members to bring complaints against others when they see a violation. And in some of the areas where people see incompatibility between the Chinese system and more market-oriented systems, the complaints did not come quickly enough or were not ambitious enough. I read paragraph 46 above as setting out a broad obligation in this area, and yet it hasn't been the subject of a formal complaint, despite all the concerns over the years about the behavior of Chinese SOEs.
I've tried to figure out why this was the case, and I hear various explanations. One part of the answer seems to be about gathering evidence, and I'm sympathetic to that problem, although I think DSU Article 13 can help here. Another part is almost certainly that the U.S. was distracted with the War on Terror in the time period immediately following China's WTO accession. If the U.S. had made China's trade practices (and human rights practices) a primary focus back then, things could have turned out very differently. But the focus was elsewhere and challenging China got in the way of that.
Eventually, Obama "pivoted to Asia" and pushed for the TPP, policies for which China's rise was an important element; and the Trump administration had its aggressive approach to trade, which attacked everyone, but perhaps China the most. But neither of these efforts were really focused on the WTO commitments China made and the compatibility of China's practices with WTO rules. The TPP would have added new rules but they would not have applied to China; and while the Phase One trade deal did add new rules in areas related to non-market practices, it did not include a neutral adjudication mechanism that could induce China to comply with these rules. Instead, it just threatened more unilateral tariffs, and Trump's Section 301 tariffs showed how China would react to that approach.
It would have been better if people had focused on these issues earlier, but it's not too late to use existing tools. WTO obligations offer some possible avenues for governments seeking to address China's practices (although these rules might benefit from some refinement). How far can these tools go in dealing with the compatibility problems and the distortions to comparative advantage? I'm not sure, but it seems like it is worth a try, especially since no one has come up with alternatives that could work better.
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