A New Approach to Rebalancing the U.S-China Trade Deficit

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Three years of trade war and supply disruption from the pandemic have the United States looking to reverse decades of migration of American production lines to China and the resulting loss of industrial capability and manufacturing jobs.

The U.S. government wants to rebuild domestic production, especially of critical items, and reduce dependence on an increasingly hostile strategic rival, and U.S. corporations are rethinking their sourcing risks given that China President Xi Jinping could shut down shipments to the United States at any time.

The one policy tool that would do both is a cap-and-trade system that would entail the U.S. government issuing rights to import certain dollar amounts of Chinese goods and then allowing those rights to be traded.

The Need for a New Approach

Other tools have failed: U.S. imports from China continue to rise and in 2021 will likely exceed the pre-trade war 2018 peak of $539 billion. If the United States were to raise existing tariffs on Chinese goods or impose new ones, China could easily follow suit as it has in the past; tariffs also create uncertainty for buyers in terms of their duration and the likely tit-for-tat responses they provoke. The United States has won the lion’s share of the complaints it has filed with the World Trade Organization against China for issues involving individual products, but by the time the WTO has completed the long adjudication process and levied a penalty tariff, the damage has been done.

The United States has not tried local content rules or a large-scale subsidies program to try to help U.S. manufacturers compete with Chinese rivals. But they aren’t a feasible solution because they would invite political gaming by every industry seeking protection, and the federal government has neither the charter nor the dedicated department to manage such in a strategic and timely way. The United States cannot match China’s elaborate industrial policy and should not waste money trying.

China currently sells four times to the United States what the United States sells to it. Given China’s systemic production cost advantage, which now averages 30% to 35% even when shipping costs are included, and Beijing’s determination to replace imports of America’s superior technology-intensive products, such as semiconductors and jet aircraft, with its own, nothing short of a ceiling on total U.S. imports from China is likely to reduce the trade gap.

The case for a system to limit imports from China is strong. The U.S.-China trade relationship started with a macroeconomic mismatch between the United States, with its open markets, low investment in infrastructure, rich technology, large investments by its multinational corporations in overseas production, and overvalued (for trade purposes) currency, and China, with its closed markets, low costs, high investment in infrastructure and industrial capacity and managed undervalued currency. Once the two economies were directly connected by China’s 2001 entry into WTO, a growing flow of technology, production, jobs, and savings from the United States to China was inevitable. As many as 3.7 million U.S. jobs have been lost due to the U.S. trade deficit with China since China’s WTO entry, according to various estimates.” The normal adjustment mechanism of market-driven currency value changes could not operate, as China’s yuan was essentially pegged to the dollar.

China made big concessions to get into the WTO but subsequently didn’t live up to its promises: It didn’t open its vast government procurements to foreign companies, continued to shower subsidies on its state-owned technology sectors, and held foreign companies wishing to do business in China hostage to technology-sharing requirements. For 20 years China has dragged its feet on granting U.S. companies access to its market equivalent to the access to the United States that its companies enjoy. It has subverted the notion that a country should sell items that it has a comparative advantage in producing and buy from other countries those it doesn’t — the cornerstones of the world trade order.

How a Cap-and-Trade System Would Work

The core idea of my envisioned cap-and-trade system comes from a proposal that Warren Buffet made in 1987 to reduce the U.S. trade deficit by issuing exporters import certificates equal to the dollar value of their exports. U.S. companies wishing to import goods would have to buy the certificates, which would be traded in an “exceptionally liquid market.”

Such a cap-and-trade system for imports from China would be much like the one for greenhouse gas emissions in various parts of the world. The beauty of this system is its insulation from political favoritism and bureaucracy: Market forces would determine who buys licenses and what gets imported. The cap’s level can be managed relative to a target such as GDP or the size of the trade deficit.

The cap-and-trade system I have in mind would work as follows. To avoid market disruption and let the United States resolve its current worker shortages and logistics bottlenecks, all current import arrangements would be initially honored and the cap-and-trade scheme would be phased in over one to two years. Companies importing Chinese items with the bigger cost or quality advantages over competing U.S.-made items would be able to afford to pay higher prices for the licenses, while the importers of Chinese goods with the least advantage would be able to pay little or nothing for licenses, because they wouldn’t be able to recover the price; this would allow American suppliers closest in cost and performance to compete under the cap.

(The U.S. government could take other steps outside of the cap-and-trade system, such as providing subsidies or guaranteed government purchases, to ensure that there is adequate domestic capacity to produce certain products deemed essential to the country, such as personal protective equipment (PPE) and critical medicines.)

For administrative simplicity, licenses would be sold at an auction. They would convey rights to the importer, who would then choose the products to import or sell the licenses to someone else.

A sunset provision for the whole cap-and-trade system would be essential. It would make its renewal after, say, five years contingent on U.S. suppliers’ success in bringing prices down tolerably close to pre-license imports’ levels. So if the United States cannot resolve its shortage of skilled workers and raise its overall competitiveness through better infrastructure, more legal immigration, lower health care costs, and so on, the cap-and-trade system would cost too much and would need to be scrapped. The system alone cannot bring back the U.S. supply base for many industries.

The time horizon has to be long — at least five years — given that rebuilding the U.S. industrial commons in many industries will take years. Domestic suppliers of critical intermediate materials and skilled people needed to make lots of things have disappeared over the last three decades. For example, U.S. companies willing to tool up to make N95 masks when severe shortages of them occurred during the pandemic had trouble finding domestic sources of the non-woven filtering fabric and specialized machinery needed to fabricate the masks. U.S. companies did add the equipment needed to make masks only to have big hospital buyers go back to cheaper Chinese masks once supply caught up with demand. Without the assurance of a future market, domestic companies will hesitate to commit to investing in plant, equipment, and workers.

The economic cost of the cap-and-trade system would be modest. For example, if the United States were to replace a full one-quarter of China’s current imports at a worst-case 35% higher initial price, it would cost the United States less than 0.3% of GDP and would not have a significant impact on inflation. That price would be a small one to pay given the large benefits that would be generated in the form of a stronger domestic “industrial commons,” more jobs, and healthier communities.

Other Benefits

Beyond those I’ve discussed, the benefits of a cap-and-trade system include the following:

Encourage, but not mandate, reshoring. The cap lets U.S. multinationals that now source materials and manufactured items from China to supply the American market decide whether to maintain those practices, switch to U.S.-based suppliers, or diversify by adding suppliers in other countries (“China Plus One”). This kind of shift was occurring even before the pandemic hit.

For example, specialty chemical companies have been moving their purchases of some high-grade raw materials from Chinese to U.S. suppliers because the latter are available, the cost difference between the American and Chinese materials is not large, and the lead times to fill customers’ orders is short. And American robotics producers concerned about Chinese supply disruptions, which have already occurred, are shifting their sourcing of key components to Taiwan, Israel, and the United States.

On the other hand, U.S. port operators will continue to purchase Chinese large cranes to load and unload ships because the cost advantage is large, standardization (i.e., using one type of crane) saves money, and order lead times are long and more forgiving. Similarly, large apparel brands such as GAP and Liz Claiborne will continue to purchase highly tailored women’s clothing items from China because of its local manufacturers’ superior know-how and deep local supply chains. Apple is diversifying its iPhone assembly locations but is not leaving China. So don’t expect a reshoring stampede.

Push Chinese companies to expand their U.S. presence. The cap-and-trade system would accelerate the move of Chinese suppliers to the United States. A number have already made this move. For example, Fuyao Glass, China’s leading auto glass manufacturer, now produces in the United States, accepting the higher costs to be closer to customers whose orders change daily and to insulate itself from any U.S.-China political dramatics. And Sany, China’s leading excavator producer, is now assembling machines in the United States.

Slow China’s capture of supply chains for high-tech-products. China has used the combined rapid growth of its domestic market and exports to rapidly build dominant production-scale advantage — and thus cost advantage — in established high-tech products, such as solar panels, drones, and surveillance cameras, and important new ones, such as electric cars and advanced batteries. If these products had to compete with more established Chinese exports for U.S. import licenses, it would effectively raise their costs and give U.S. competitors a chance to compete on price and manufacture them at home. Many high-tech products have been first developed in the United States but their production has quickly shifted to China. The imports cap could slow down this outsourcing.

Allow the U.S. government to achieve other policies. It is hard to imagine any U.S. administration being able to sell Congress on another far-reaching trade agreement, such as the Trans-Pacific Partnership, without a mechanism to reduce the trade deficit, protect domestic suppliers of goods and materials deemed critical to national security, and manage trade with adversaries such as China. The cap-and-trade system would also preserve the economic and geopolitical advantages of the strong U.S. dollar and help maintain it as the dominant global reserve currency.

Bring stability to U.S.-China trade relations. Mainstream economists will likely oppose the introduction of a cap-and-trade system, arguing that it that would raise costs to consumers and lead to Chinese retaliation and trade chaos. But in fact, any policy aimed at rebuilding the U.S. supply based — whether by tariffs, subsidies, local content rules, a carbon tax on imports, or currency devaluation — will raise costs initially and trigger resistance from Beijing. But Beijing will prefer the stability of an imports cap to the unpredictability and disruptions of trade wars.

Insure against future import surges. China’s central and local governments will be mounting new export subsidy programs to replace the big hole in GDP caused by the volatile, debt-ridden real estate and construction sector.

The Communist Party of China has exploited its trade relationship with the United States for 20 years. It is past time that the United States did something about it. Powerful countries do not just let such predatory behavior go on and on.