China's economy now second only to U.S.: What does the future hold?

September 01, 2010

On August 16 the Japanese Cabinet Office announced that Japan's second-quarter GDP was for the first time smaller than China's. A media frenzy ensued, proclaiming China's economy larger than Japan's (and second only to that of the United States). Analysis firms raced to predict when China would surpass the U.S. -- PricewaterhouseCoopers pegs 2020; Goldman Sachs claims 2027.

As a practical matter, China's GDP is less than 60 percent that of the United States. And because China's population is four times larger, even if its GDP equaled the United States', its per capita GDP -- a proxy for living standards -- would still be one-fourth America's.

Why the U.S./China relationship matters

But while China's newfound status as the world's second-largest economy might not portend its imminent grab of the No. 1 slot, it does prove -- lest anyone still doubted -- that China is an incredibly important, not-to-be-ignored player on the world economic scene. It means, said Michael Pettis, finance professor at Peking University, that China and the U.S. will have to tackle the world's biggest problems together. "Whether we're talking about global warming or nuclear proliferation or global terrorism or the world's water crisis, it's going to require Chinese participation."

Arthur Blakemore, chairman of the economics department at the W. P. Carey School, explained the importance of the U.S./China relationship this way: "The question is not whether China’s growth necessarily makes the U.S poorer; it doesn’t. Rather, the question is: Will we adopt the practices and policies that best promote our future technological progress, and hence a sustained growth in our standard of living; or will we adopt policies that sacrifice long run income gains for short lived protections?"

Pettis and Blakemore, along with a host of other experts including W. P. Carey Dean Robert Mittelstaedt and economics Professor Edward Prescott, are participating in a new online community called FutureofUSChinaTrade.com. A joint venture between Arizona State University and the Kearny Alliance, the site is a center for data, analysis and discussion on issues surrounding the U.S./China relationship.

The website offers a guided discussion framework, which in its first phase asks participants to consider three different scenarios of the future of trade between the two countries. "We should move toward a vision of what a great U.S./China relationship looks like. Let's write an abstract story of the ideal relationship, then we'll decide how to get there," explained Mittelstaedt, who moderates the Free Trade scenario.

Scenario 1: Free Trade

In that scenario, Mittelstaedt imagines a future where trade is really unfettered. "Free trade allows countries to compete on the basis of their comparative advantages -- doing what they do best -- not on their protectionist policies. It means countries sell what they're best at on the open market without restrictions," writes Mittelstaedt in his scenario sketch.

That means a significant departure from the current modus operandi (more so in China than in the U.S.), including the following: China allows its currency to float freely against the U.S. dollar; policymakers end trade barriers such as import quotas and tariffs; governments end subsidies to certain industries or firms; and both foreign and domestic firms are asked to play by the same rules.

The real question that arises from the Free Trade scenario, Mittelstaedt said, is how it would change the countries' comparative advantages, which are now distorted by protectionist policies. "Likely, China's comparative advantage in a world of truly free trade would be some logical extension of China's comparative advantage today (likewise for the U.S.)," Mittelstaedt writes. "Why? Because the U.S. and China already have economies of scale in certain industries and momentum toward growing certain industries."

Some types of production -- certain agricultural products in the U.S., for example -- might disappear if trade were truly free. And while Mittelstaedt acknowledges that such a shift would generate economic losses for those producers, "over the long term, and on net, we all benefit from free trade."

To deal with a future where trade is truly free and production is dictated by each country's comparative advantage, Mittelstaedt says that market flexibility -- the ability of the education system to teach new skills, the ability of producers to produce different goods and services -- is critical, because "in a world with truly free trade, comparative advantages constantly change."

"Those countries best able to adapt to those changes will grow the fastest. Everyone realizes economic gains, because they're doing what they are best at and buying what they can't produce most productively. It's economic efficiency at its finest."

Scenario 2: America Competes

"America Competes" moderator Clyde Prestowitz, a trade policy expert and founder of The Economic Strategy Institute, envisions a very different future for trade between China and the United States. In his scenario Prestowitz imagines America taking a competitiveness stance, working to reverse the erosion of its economic power. At the same time, China focuses on growth led by domestic demand rather than exports.

Prestowitz begins his sketch by recounting some of the ways in which America has declined. "America's wealth-producing capacity has waned," he writes, adding, "It's not irretrievable, but the hour to do so is getting late."

According to Prestowitz, America's decline is the result of an inaccurate view of the way the world works. "Our assumptions about how the global economy should work are really shared only by the United Kingdom -- not by Germany, not by Japan, and not by China." So while the United States is playing by its own set of "free trade" rules, its largest economic competitors are playing by a different set of rules entirely -- rules Prestowitz labels "strategic globalization."

Strategic globalizers "actively use government to promote jobs and trade," Prestowitz writes. If U.S. policymakers were to take his advice and develop their own globalization strategy, it might include offering federal incentives designed to promote foreign direct investment in the U.S.; reducing the corporate tax rate; developing a "Rebuild America's Infrastructure" program; or assigning a Competitiveness Czar to indentify industries in which America could compete and proposing measures to ensure that those industries flourish.

Prestowitz stresses that his vision of the future is not about the U.S. stopping China from being successful. "It's not a zero-sum contest. It is instead about America doing what China has long done -- competing, for its own self interest. It is about America doing what is good for America," he writes.

Scenario 3: Convergence

In the third scenario, "Convergence," Arthur Blakemore envisions a convergence of growth rates: the U.S. continues to grow on trend (about 2 percent per year) and China moves through the catch-up phase (growing about 9 percent a year) to become a developed economy. When that happens, China's growth rate slows and its development, like the U.S.'s, comes to depend on technological innovation.

Blakemore acknowledges that his vision of the future relies on the U.S.'s commitment to the policies that have sustained it as a growth leader. He sees some warning signs that commitment might be waning: increased intrusion into the market by the government, fiscal imprudence, and relatively poor educational performance at the primary and secondary levels.

"Yet there are more compelling reasons to think that the U.S. will continue its trend growth," Blakemore writes. "Among the reasons favoring prolonged prosperity are: a relatively flexible market, world-class higher education, strong investment and performance in research and development, strong enforcement of the rule of law, and high-quality regulatory practices."

In China, Blakemore imagines that the economy continues to grow rapidly as workers move from less-productive agricultural jobs to more-productive manufacturing jobs. Yet as that shift advances, as "workers are increasingly reallocated into higher productivity sectors," wages rise.

"As a consequence, Chinese firms find it more difficult to compete with newly developing economies in the lowest-end, lowest-cost manufacturing sectors. But at the same time, Chinese firms become more technologically capable (by following the leaders), and better able to compete in higher-end manufacturing and services." That is what Blakemore calls the second phase of China's economic development, where "as productivity gains are less easily attained," growth slows.

Moving from that second phase of economic development to the advanced phase where growth is fueled by technological advancement, China will have to further reform its institutions and open its markets, Blakemore said. He cites improving education and infrastructure; fiscal, tax, and financial restructuring; and trade policy transformation -- many already announced by China's State Council -- as examples of necessary reforms.

Like Prestowitz does, Blakemore emphasizes that the U.S./China relationship is not a zero-sum game. "It is important to remember as we imagine the convergence of growth rates of U.S.-China that the growth of China does not require or even imply the decline of the U.S. … If America maintains its place on the frontier of technological innovation, the 'catching up' of China does not mean any sort of decline of the U.S. In the end: China is richer. The U.S. is richer."

"The consequences of divorce are unacceptable"

Understanding the most likely future of U.S./China trade is an important prerequisite for the development of effective trade policy. If China is likely to take a freer-trade stance, the optimal U.S. strategy would be very different than if China continues its policy of "strategic globalization." Likewise, if the U.S. develops a more competitiveness-oriented stance, China's optimal strategy would be very different than if America were to become a true free trader, as Bob Mittelstaedt envisions.

As Michael Pettis and Arthur Blakemore articulated, America and China are now inextricably intertwined -- with each other and with the rest of the world. As Buck Pei, dean of Asia Programs at the W. P. Carey School explained, "Both the U.S. and China must realize that working together, they will both be better off than in divorce. The consequences of divorce are unacceptable."

That makes a productive dialogue all the more critical.

Bottom Line:

  • While China's newfound status as the world's second-largest economy might not portend its imminent grab of the No. 1 slot, it does prove -- lest anyone still doubted -- that China is an incredibly important, not-to-be-ignored player on the world economic scene.
  • FutureofUSChinaTrade.com fosters discussions about the future of the U.S./China relationship. The site offers a guided discussion framework, which in its first phase asks participants to consider three different scenarios of the future of trade between the two countries.
  •  In the first scenario -- "Free Trade" -- moderator Bob Mittelstaedt imagines a future where trade is really unfettered and the United States and China compete purely on their comparative advantages.
  •  In the second scenario -- "America Competes" -- moderator Clyde Prestowitz imagines America taking a competitiveness stance, working to reverse the erosion of its economic power. At the same time, China focuses on growth led by domestic demand.
  • In the third scenario -- "Convergence" -- moderator Art Blakemore imagines that the U.S. continues to grow on trend (about 2 percent per year) and China moves through the catch-up phase (growing about 9 percent a year) to become a developed economy.
  • Understanding the most likely future of U.S./China trade is an important prerequisite for the development of effective trade policy.

FutureofUSChinaTrade.com invites participants across the globe and from all perspectives to join the discussion on the future of U.S./China trade.