Obama’s Home And The Report Is Out: China Takes Us To School

President Obama is home from China and the U.S.-China Economic and Security Review Commission today releases its 2009 report to Congress [1]. What have we learned? That we need to pay attention because we’re getting schooled.

While Obama posed for photos on the Great Wall and talked about a relationship “at an all-time high [2]," China continues to take our lunch money. Hopefully, there were serious back-room negotiations over currency manipulation [3]and illegal subsidies … because if not, we’re in trouble.

Don’t take my word for it. The official, bipartisan China commission held hearings, traveled to China and received closed briefings on classified information. They reported back about expansion of the Chinese navy, China’s stepped-up espionage and cyber-warfare capabilities, and the world’s most sophisticated web filtering and Internet control systems.

But the economy is behind it all. China is quite literally eating our lunch. Since 1980, the U.S. has accumulated a trade deficit with China of nearly $2 trillion. The biggest piece of this trade deficit is in manufactured goods, once the wellspring of American prosperity. And a big piece of that comes from China subsidizing industries and manipulating currency [3]in a way that gives their exports a competitive edge. China then takes our money and lends it back to us, creating both national indebtedness and a destabilizing excess of liquidity that helped fuel our asset bubbles.

This year's report reflects the commission's concern that despite its accomplishments and growing sense of confidence, China may be moving in the wrong direction and that this affects the U.S.-China relationship. China has yet to embrace the challenge first issued in 2005 by the United States that it become a "responsible stakeholder" in world affairs (p. 15).

The report reads like an indictment of Chinese behavior and American compliance. The most glaring problem is the subsidies.

China continues to employ a wide range of subsidies to favored companies and industries within China and to control the value of its currency and provide massive loans from state-owned banks to industries producing over capacity. This approach gives Chinese exporters a substantial price advantage in international markets and disadvantages U.S. companies hoping to export to China.(p. 15).

The report itemizes subsidies in the form of land grants, discounted electricity, and loans from state banks at below market interest rates or “without expectation of repayment” (p. 59). As a whole, the commission concludes that the subsidies and special treatment of Chinese-owned companies “violate China’s obligations as a member of the World Trade Organization” (p. 59).

The report goes on to describe export restrictions (p. 62), currency manipulation (p. 68), double-standards on domestic content (p. 52, 64) and China’s failure to enforce its laws on forced labor, child labor and environmental standards (p. 67) that were key to gaining international investment and foreign government support. The findings go far to explain why products made in China are so much cheaper than products made in America, and the incentives behind our gargantuan and growing imbalance in trade.

The report also explains how the imbalance goes beyond the trade in goods, and helped bring the whole system down. The commission places responsibility for the global economic meltdown “partially on the United States as the world's biggest spender and borrower and partially on China as the world's biggest saver and lender.” But it’s not because Chinese are inherently parsimonious or frugal. “China pursues policies that have the effect of increasing Chinese savings, restraining consumption, and keeping the RMB (renminbi) undervalued” (p. 3). The saving was as out of balance as the spending.

The imbalance extends all the way to the banks. China had hundreds of billions of American dollars, and needed something to do with them all, so they lent them back to us. “The policies that China adopted generated a huge flow of liquidity —or money that can be easily lent to borrowers — into U.S. markets. This excess liquidity created perverse incentives in the United States that encouraged banks to make risky loans to U.S. households, which in turn grew ever more indebted. High U.S. demand for imports allowed China to save even more, creating a vicious cycle and laying the foundation for the current crisis” (p. 4).

So it collapsed. The unstable structure tumbled down.

In the aftermath, the U.S. passed its own Recovery Act and led efforts for international collaboration. But what did China do? More of the same. The commission reports that China stimulated its economy by raising rebates to exporters and offering other advantages to see manufacturers through the downturn (p. 40). In the words of the Commission:

The fact that the government in Beijing is still pursuing an export-led strategy based on a wide variety of subsidies to export industries, including an RMB that remains substantially undervalued, is a cause for concern. If China continues to pursue huge trade and investment surpluses and to accumulate vast financial claims, it will hinder the necessary global economic adjustment, create excess manufacturing capacity, and lay the groundwork for the next crisis.” (p. 2)

We don’t need to watch it fall apart all over again. Cheap Chinese exports to distressed U.S. consumers are not the answer. The report advances 42 specific recommendations, from responding to currency manipulation to increasing our defenses against cyber-espionage. A crucial minimum is aggressive use of World Trade Organization trade remedies. We’ve started moving in that direction with cases on tires [4]and steel pipes [5]. The Commission recommends that the U.S. government preserve and use existing remedy laws “to respond to China's unfair or predatory trade activities” (p. 12).

Obviously, nobody wants to start a trade war and nobody thinks we can unwind the global economy. This isn't about protectionism or going backwards. It’s about building a global economy with agreed-upon rules of free trade that every country follows. From rugby to poker, rules make systems work. Following rules is what China agreed to when it entered the G-20 and was granted permanent normal trade relations with the U.S.

There’s a purely domestic angle, too. Between the lines of criticism is a hidden story, implicit advice about fixing our own economy. Parts were illegal and parts were unfair, but China’s success shows how deliberate industrial policy helped it accomplish strategic goals. Indeed, a summary of China’s misdeeds reads almost like a “how-to” list for industrial policy: Subsidize strategic industries, especially energy (p. 57, 65). Enhance innovation by creating “industrial commons,” clusters of producers, suppliers and researchers in close proximity who support each other in uncovering problems and discovering solutions (p. 87). Build an infrastructure, especially on transportation, with domestically produced parts (p. 64).

Now the U.S. can’t be like China in every regard, and we wouldn’t want to be. But we might as well learn some lessons while we’re in school. As the Commission observes, “A widely shared goal in China is to make the country rich and powerful and to regain the nation’s former status as a great power that controls its own fate” (p. 56).

That’s their goal and they made a plan to achieve it. What’s our goal? How are we going to get there? [6]