Trade, China and the World Economic Order, Part 1: The Mechanics, and History, of Global Trade

March 24, 2009

The issue of trade is particularly germane as countries around the world try to dig themselves out of the economic crisis -- a crisis that is truly, perhaps unprecedentedly -- global in nature. The Economist magazine issued a stark warning on February 5, 2009 to countries that would respond to the crisis by closing their borders to trade:

"[T]he reemergence of a spectre from the darkest period of modern history argues for a different, indeed strident response. Economic nationalism -- the urge to keep jobs and capital at home -- is both turning the economic crisis into a political one and threatening the world with depression. If it is not buried again forthwith, the consequences will be dire."

It's a warning that 2004 Nobel Laureate and W. P. Carey School professor of economics Edward Prescott echoed when he opened the forum's discussion by declaring that "economic integration is the path to riches and peace." Prescott replaced the word "trade" with economic integration -- reflecting a much broader, more complex relationship.

Developing countries (Japan, South Korea, Taiwan, Hong Kong, and Singapore) that have economically integrated with industrial leaders like the U.S. have caught up with those leaders in terms of GDP. Those five Asian countries averaged 31 percent of the U.S.' GDP per capita level in 1961, but had advanced to 67 percent by 2001. Yet the opposite is also true. In Latin America, for example, countries are not "catching up" economically because they're not economically integrated with one another, Prescott explained.

Economic integration drives economic growth in developing countries for four reasons, Prescott said. First, through economic integration the less-developed country (China, for example), gets access to foreign know-how -- technological capital -- which it can then adopt to become more productive. "Multinational companies use their technological know-how in their foreign subsidiaries, so reciprocal multinational relationships are key -- they lead to a vested interest in both countries to remaining open," Prescott said.

Second, if development is constrained within a country's own economy (the country is not economically integrated), then productivity increases growing out of better technology lead to decreased employment (as more efficient production requires fewer workers). But, if development can spill outside the country's own economy, then productivity increases lead to increased output and increased employment.

Third, economic integration allows a more rapid diffusion of knowledge -- which is key to productivity growth. "A lot of technological capital has to be absorbed person-to-person," Prescott said, "and that happens more quickly if countries are economically integrated."

Finally, economic integration invites competition, which Prescott calls "a powerful motivator for economic development." When the first six European Union countries integrated, he said, the mere threat of competition in France from German firms led French firms to become more productive.

The more integration, the better?

W. P. Carey School of Business Dean Robert Mittelstaedt recounted a conversation he had with a New York City cab driver, who plainly stated his opinion that the U.S. shouldn't trade with China because "we need to keep jobs in the U.S." Mittelstaedt asked the driver if he enjoyed paying low prices at Wal-Mart. "Of course," was the answer. "Those lower prices are a direct result of trade with China," Mittelstaedt replied. Though his logic was clearly breaking down, the cab driver stood his ground that, simply, American policymakers should do everything they can to keep U.S. jobs in the U.S.

Indeed, the perception that economic integration is only good for one of the countries is common in the U.S., but Prescott said that more integration is better for everyone. If economic leadership is a club, "we all gain from having more people in the club." He forecasts that by 2100 the whole world will be rich -- because of economic integration.

Contrary to popular opinion, Prescott argued, the pie grows bigger as more countries come to the table. "The set of industrial leaders is expanding. Once a country is in that club, it stays in." In other words, the economic development of China won't hurt the U.S. "In the category of economic superpowers, more is better than less -- the more technology those leaders develop, the more we all benefit."

But even among the forum participants, significant debate erupted over the idea that economic integration benefits all -- that it makes the pie bigger, rather than simply enlarging some countries' slices and shrinking others'.  Perhaps even more significant, some suggested, is the concern that pursuing economic development and measuring that development only by GDP may be unsustainable given the earth's finite resources.

"It's easier for economists to calculate the gains from trade than it is to calculate the costs. Adjustment costs associated with economic integration are underrepresented economically," said Clyde Prestowitz, Jr., founder and president of the Economic Strategy Institute.

Paul Schiff Berman, dean of the College of Law, pointed out that we may need to think of trade within a broader regulatory framework that focuses on how China and the United States can best pursue their mutual need for an economic model that is stable, sustainable, and promotes human flourishing."

Merle Hinrichs, chairman and CEO of Global Sources, articulated some of the costs -- and benefits -- from both the American and Chinese business and consumer perspectives. Among the benefits China receives from economic integration are capital investment and knowledge transfer (of everything from technology to management). Among the costs, from China's perspective, are dependencies on trade-related jobs and adverse environmental impacts.

From the American perspective, Hinrichs cited substantial consumer product choice and highly competitive consumer product prices (which contribute to slower inflation growth) as benefits of economic integration with China. Costs include a substantial trade deficit, dependencies on foreign capital, dependencies on imports, and job losses, which, especially in today's economy, have come to the fore as the primary reason behind calls for the U.S. to back off economic integration with China.

Sticking points: Terms of integration

Defining the pros and cons of economic integration is likely not the most difficult task, Prestowitz suggested. "Economic integration is obviously important -- that's easy to say. But part of the issue is the 'how' of integration -- that's the key question in globalization, especially in the U.S./China relationship."

Mittelstaedt suggested that the problems we face with trade today are similar to those faced throughout history; trading partners say, "I want what you have but I'm not sure I want to trade with you on an even basis."

That's certainly been part of the history of trade in the U.S. "The United States integrated economically on its own terms," said Prestowitz. During the 19th and first half of the 20th centuries, the U.S. pursued "catch-up" policies that included highly protective measures. President Lincoln, for example, increased tariffs 60 percent. Teddy Roosevelt said, "Thank God I'm not a free trader."

Protectionist policies were designed to help the United States catch up, developmentally, with then-leader Great Britain. At the same time, Britain, which led the Industrial Revolution, felt free to pursue laissez faire ("hands off") trade policies. But in the late 19th century, countries like the United States -- following policies much like the Asian developing countries follow today -- caught up with and eventually surpassed the UK. (In 1888, per capita GDP in the U.S. was 85 percent of the UK's. By 1908, U.S.' per capita GDP had risen to 103 percent of the UK's.)

By 1946 the U.S. was the dominant player in global trade -- the most productive in every industry and the technological leader. The U.S. was, in other words, the "new Britain." As the new leader, the U.S. followed a path similar to the UK's -- adopting a much more laissez faire trade policy and developing a "trade not aid" mantra designed to get war-torn countries back on their feet through exports to the U.S. Domestically, the U.S. focused on developing consumption to lead growth and stimulate exports from other countries.

"For the last 60 years, this has been the U.S. strategy -- not entirely laissez faire, but a fairly open market approach to trade and investment, with a priority focus on domestic consumption as the global growth driver," Prestowitz said.

The history of Chinese economic integration

Like the U.S. in the early 20th century, China is now moving up the "value ladder" -- from low-value, labor-intensive manufacturing to higher value, higher technology manufacturing (and, eventually, services). Since 1978, when the country moved to a decentralized, market-oriented arrangement, it has been in a period of rapid economic catch-up, what Prescott called a "growth miracle."

In 2001, China became a member of the World Trade Organization (WTO), after which "someone turned the switch and the flow of FDI [foreign direct investment] accelerated rapidly," as Hinrichs put it. Foreign-invested enterprises dominated state-owned enterprises in China's export markets.

That meant foreign companies entering China with their technological knowledge and management know-how. "Today, China has developed its own stock of those types of capital; now Chinese companies are themselves looking to locate in foreign countries and even buy foreign brands," Hinrichs said.

Like Japan, which is now considered an industrial leader, China and other developing Asian countries are pursuing catch-up strategies marked by suppressed consumption, which generates high rates of savings and the capital the countries need to invest in economic development. "In Singapore, for example, the savings rate is 55 percent (compared to 1-3 percent in the U.S.). The country then channels those savings into particular industries to increase productivity and increase living standards," said Prestowitz.

The big question today is whether or not China will join the "club" of industrial leaders. To be considered an industrial leader, Prescott said, a country must have a per capita GDP that is at least 50 percent of the top country's per capita GDP. Today, China is certainly catching up, but isn't there yet -- in 2008 per capita GDP in China was 22 percent of per capita GDP in the U.S. (up from 13 percent just 7 years earlier).

Prescott said that China will join the club in 2025 if the country's economy grows at 7 percent per year until then and becomes more economically integrated with the advanced industrialized countries. Once in the club, China will be a member for life, Prescott said. "It's an expanding set -- countries that get in, stay in."

The sustainability of global economic integration

The idea that an ever-greater number of countries would join the "economic leadership club," characterized by relatively high levels of per capita GDP and -- often -- consumption, worried many forum participants. In other words, if China's per capita GDP comes to rival the U.S.', and per capita consumption follows, what are the ramifications?

Prestowitz suggested the ramifications can be seen easily in today's global economic crisis. "A significant part of the current economic crisis is that the terms of economic integration over the last decade have proved unsustainable," he said.

"If the goal is an American lifestyle for everyone, is that sustainable?" asked intellectual property attorney Karen Dickinson. "Going forward, if China's idea is to reach America's lifestyle, the earth won't support it, and that will lead to resource warfare," said Gary Tooker, former Motorola chairman.

Others questioned the idea that economic integration leads to peace -- Prestowitz referred to "The Great Illusion," first published in 1909 by British economist Norman Angell, who argued that war is futile because of common economic interests. (Of course, just five years later World War I began.)

Thomas Friedman suggests a similar idea, what he calls the "Golden Arches Theory of Conflict Prevention." No two countries that both have McDonald's have ever gone to war, Friedman asserts. "The Golden Arches Theory of Conflict Prevention stipulates that when a country reaches a certain level of economic development, when it has a middle class big enough to support a McDonald's, it becomes a McDonald's country, and people in McDonald's countries don't like to fight wars; they like to wait in line for burgers," wrote Friedman in the New York Times in December, 1996.

Prestowitz, for one, rejected that idea. "The terms of economic integration in the early 1900s led the world toward war rather than peace." Part of the problem, Prestowitz suggested, is that if new countries join the economic club, catching up to the leaders, then some leaders inevitably lost ground. "The leaders don't like that, and that causes to conflict." The key question for the global economy is: We want integration, but on what terms, and how?

Adjusting to "a new world economic order"

W. P. Carey economics professor Jose Mendez granted that economic integration involves changes and stresses. "But we don't want those stresses to thwart the technological progress associated with economic integration," he said.

"How do we strike the proper balance between accessing the mutual benefits of trade while also dealing with concerns about labor markets, environmental standards, consumer protection standards, and the like?" asked Berman.

A prevailing fear seems to be that the U.S. is destined to follow the path of the UK: a fall from greatness after a period of economic supremacy. But Arthur Blakemore, chairman of the economics department at the W. P. Carey School, rejected the notion that the UK failed because of its laissez faire trade policies. "The UK stopped being the economic leader because it stopped developing new technologies," he said. "And technological development is the key driver of economic growth."

Certainly "catch-up" economies like China have an advantage because they start from a lower point on the economic development scale and grow at faster rates than the developed leaders. "But once those catch-up economies become leaders, they will no longer grow as fast as they had," Blakemore said.

Leaders grow because they develop technology that generates productivity improvements. Leaders have to continue developing those new technologies or they will cease growing. But the question is not, "Will one country continue to grow while the others cease growing," Blakemore said, but rather, "Are we going to keep growing together or cease growing together?"

Bottom line

  • "Economic integration is the path to riches and peace," according to Edward Prescott.
  • From one point of view, the more integration, the better. Rather than making some countries' pie slices smaller to enlarge another countries', economic integration enlarges the pie for everyone.
  • Adjustment costs associated with economic integration are underrepresented economically, however. Moreover, economic development pursued through increased consumption may not be sustainable and therefore the long-term goal must be to create a more integrated economic development model.
  • Defining the pros and cons of economic integration is likely not the most difficult task. Part of the issue is the "how" of integration: what Clyde Prestowitz called "the key question in globalization, especially in the U.S./China relationship."
  • The United States integrated economically on its own terms. In the late 19th century, following policies much like the Asian developing countries follow today, the U.S. caught up with and eventually surpassed then-leader Great Britain. As the new leader, the U.S. followed a path similar to the UK's -- adopting a much more laissez faire trade policy.
  • China will join the "club" of industrial leaders in 2025 if the country's economy grows at 7 percent per year until then and becomes more economically integrated with the advanced industrialized countries.
  • Of course, economic integration involves changes and stresses. "But," said Jose Mendez, "We don't want those stresses to thwart the technological progress associated with economic integration."
  • A prevailing fear seems to be that the U.S. is destined to follow the path of the UK -- a fall from greatness after a period of economic supremacy. But according to Arthur Blakemore, "the UK stopped being the economic leader because it stopped developing new technologies." Leaders have to continue developing those new technologies or they will cease growing.