Playing Ourselves for Fools

Amid a generally poisoned atmosphere of vicious partisan combat, trade policy is unfortunately the last bastion of relentless bipartisanship. I say "unfortunately" because there is a stunning disconnect between America's trade policy and America's national interest. Since World War II, administrations of both parties have been promoting a design for global trade that displays a studied indifference to the fate of U.S. manufacturing.

U.S. trade negotiators strive for an ever purer strain of free trade (combined with protection for agriculture but not industry). But in the real world of industrial competition, governments help their industries -- except for the American government. Dissenters from the prevailing free-trade fantasy are dismissed as protectionist, a word that ranks in the foreign-policy lexicon slightly below terrorist.

Why would the U.S. government, which has not been shy about defending the nation's military security, be such a pushover when it comes to trade? The story begins with the recovery of Europe and Japan from World War II and with the logic of the Cold War. In that era, the U.S. was industrially pre-eminent. We were building an alliance system. One of the perquisites of membership in our system was access to the huge consumer market of the United States. We were so far ahead that it didn't matter if military allies like Germany or France, Korea or Japan, practiced a somewhat different form of capitalism, namely state-led economic development, or that contrary to the dogmas of laissez-faire, state-led development actually worked.

Moreover, we had our own vast, unacknowledged system of industrial planning and research and development. It was called the Pentagon. Even as American diplomats began venturing cautious criticisms of "Japan, Inc." or "Deutschland, A.G.," and of flagrantly state-subsidized ventures such as the Airbus consortium, U.S. industry was enjoying huge spillovers from technologies created by military agencies such as the Defense Advanced Research Project Agency (DARPA) and from the research spending of the National Science Foundation and the National Institutes of Health that subsidized our great universities as incubators of industry. We were hypocrites. We had our own closet industrial policy -- though it was not coherent or strategic, and it withered over time.

Fast forward to the 1980s. By now, the state-led industrial development of nations such as Japan is more than a minor pinprick. Europe has recovered, with no small dose of planning (actually initiated by an American named Marshall.) The Cold War is ending. China is knocking on the door. Entire domestic industries are being displaced. The role model for newly emergent nations is not the laissez-faire model that the United States is promoting to the world but frankly mercantilist forms of capitalism such as those of Korea and Brazil.

So what did the United States do? It would have made sense for our leaders to realize that we were no longer in the cozy womb of 1950s industrial supremacy. We might have initiated a new round of trade talks intended to clarify which policies of industrial aid, applied research-and-development assistance, wage subsidies, regional policies, domestic content requirements, and other forms of mercantilism are legitimate tools of economic development and which ones are predatory. We might have created robust tribunals to identify and punish illicit behavior. We might have used our still-substantial economic leverage to deny market privileges to flagrant and chronic violators. We might have devised an industrial policy of our own.

But we did none of these. Instead, we doubled down on a fantasy of ever purer free trade that nobody else really bought. But if we were willing to play by the rules of an imagined free trade while others practiced state-led growth, our trading partners were more than happy to indulge our delusion.

Why did America behave this way? The reason for this seemingly irrational trade diplomacy was one part military goals crowding out industrial ones, one part ideology, and one part the increasing influence of Wall Street.

The military part of the story is little appreciated. As the leader of an alliance system, the United States promotes the idea that allied nations should have common weapons systems, ideally American ones. But other nations have demanded in return that before they agree to buy very expensive fighter planes, we must agree that most or all, and in some cases more than 100 percent of the plane, be produced in the purchasing country. This is known as domestic content. (How can more than 100 percent of a product be made in the importing country? As part of the deal, the seller agrees to buy other products from the customer nation. This is called an offset. Boeing has found itself having to use or unload billions of dollars of gadgets made in Poland or Korea that were part of offset deals negotiated by the Pentagon.) Paradoxically, the need to do military deals for U.S.?designed weapons has actually turned out to be a big export loser for U.S. industry, for it has accelerated the transfer of production technology and the offshoring of manufacturing to mercantilist competitor nations. These military bargains, further, set a bad precedent that the U.S. government acquiesces to content requirements that have come back to haunt us in purely commercial deals.

Then there is ideology, also known as neoclassical economics. Within the economics profession, only a very self-confident (and tenured) economist is willing to challenge the dogmas of free trade, and when such challenges are ventured they are done with careful disclaimer and politesse. The young Paul Krugman made his scholarly reputation by very gently, and with impeccable algebra, questioning some of the theoretical assumptions of free-trade theory. Laura Tyson, just before her appointment as President Bill Clinton's chief economic adviser, published a brave book in 1992, Who's Bashing Whom, cataloging all the ways that foreign governments advantage their industries. But by the time Tyson took office, she and such other advocates of more muscular trade diplomacy and industrial policy as Robert Reich were marginalized by the Wall Street wing of the Clinton presidency: Robert Rubin, Larry Summers, and their allies at the office of the U.S. trade representative.

Free-trade economists provided intellectual cover, but the push for ever "freer" trade mainly came from the U.S. financial industry seeking global reach and from allied industries eager to produce in the cheapest possible location far from all forms of domestic regulation. Rather than trying to create a trading system that offered a level playing field for U.S. industry, the free-trade establishment launched a broad expansion of its hapless efforts at being laissez-faire to a skeptical world, in the so-called Uruguay Round of trade negotiations, launched in 1986 and completed in 1994. Despite some weak gestures toward greater symmetry, the Round was mainly aimed at global deregulation.

Ostensibly, the Uruguay Round aimed at breaking down "non-tariff barriers," protecting intellectual property and above all opening up trade in "services." Some of this sounded good. If the global trading system came down hard on nations like Japan and Korea whose manufacturers often pirated and copied American technologies, this would be a blow against foreign mercantilism. But the new intellectual property protections had little beneficial effect on U.S. industrial innovations. With violations rampant, enforcement through the World Trade Organization process was selective. Mostly, cases had to be tried in the courts of the offending countries, which almost never ruled against local manufacturers. But the new WTO rules did forbid preventing the U.S. from imposing retaliatory sanctions through its unilateral intellectual-property enforcement mechanisms, which had been permissible before the Uruguay Round.

"Services" turned out to mean mainly financial services -- the global financial bubble that crashed the economy. The real teeth of the Uruguay Round had to do with promoting financial deregulation and making it more difficult for nations to control their own financial systems.

The North American Free Trade Agreement of 1993, likewise, was less about trade and more about making it easier for U.S.?based multinationals and banks to take over Mexican companies and to set up branch plants in Mexico for re-export to the U.S. It also had the handy and deliberate side effect of defining a lot of ordinary health, safety, and environment legislation as a violation to the free-market precepts of NAFTA. A plan to extend this principle to all of the Organisation for Economic Co-operation and Development member nations, the proposed Multilateral Agreement on Investment, was averted in 1997, when word of the scheme was prematurely leaked and a storm of protest killed the plan.

In 1999, when China was negotiating its entry into the WTO, it was a lot weaker economically and financially, and the stench of the Tiananmen massacre still lingered, the U.S. had far more diplomatic leverage than the rather pitiful show of humility befitting a debtor nation displayed on President Barack Obama's recent maiden trip to Beijing. But as the memoirs of both Robert Rubin and Joseph Stiglitz confirm, that leverage was used mainly to gain access for U.S. banks and insurance companies to Chinese markets, not to require China to modify its system of predatory industrial mercantilism.

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Curiously, the high watermark of American pushback against Asian mercantilism came during the Reagan era. Though Ronald Reagan was ideologically a free-marketer, he was also a nationalist. At the time, there was still a large rump group of U.S.?based manufacturers such as Intel, Motorola, Boeing, Corning, and others, which functioned as a lobby against foreign mercantilism. The military was also alarmed that we might be falling behind in technologies critical to the national defense. Reagan's purely economic advisers were traditional conservatives, but his trade officials, led by Clyde Prestowitz, mounted an offensive against foreign, most notably Japanese, mercantilist practices, and actually made some headway. The pre-WTO 1980s were also the golden age of DARPA, of the Plaza Accord that enlisted the cooperation of other nations in reducing an overvalued dollar in a fashion that made U.S. products more competitive without roiling money markets, and of the Super 301 provision of U.S. trade law, which allowed effective retaliation against unfair foreign trade practices.

But beginning in 1989 with George H.W. Bush, and continuing under Clinton and George W. Bush, the U.S. government largely ceased defending U.S. manufacturers against predatory practices of foreign companies and states. Most American multinational companies, abandoned by their government, have been left to make a separate peace with foreign mercantilist practices.

That means accepting deals to shift their research, technology, and production offshore, sometimes in exchange for explicit subsidies for land, factories, research and development, and the implicit subsidy of low-wage and powerless workers and weak environmental or safety requirements. At other times, the terms of the deal are more stick than carrot: If you want to sell here, the companies are told, you must manufacture here. Or even worse, you can manufacture here but only for re-export to your own domestic market and not for local sale.

For the most part, American industry has accurately concluded that the U.S. government could not care less where it manufactures. This is true of both traditional low-skill industries, which are often seen as logical candidates to move offshore, and the most advanced industries as well. Prestowitz tells the story of an American entrepreneur named Igor Khandros, a man who epitomizes why the U.S. possesses -- and squanders -- great competitive advantage.

Khandros, an engineer, was a refugee to the U.S. from what was then Soviet Ukraine. He worked at IBM and eventually invented a brilliant new technology for testing semiconductor wafers. By 2000, he was president of his own company, FormFactor, which now has $500 million in sales, employs 1,000 people in Livermore, California, and exports 80 percent of its products -- an all-American success story.

A Korean firm, Phicom, paid Khandros the ultimate compliment. It stole his technology. Unable to get redress in the Korean courts, Khandros enlisted Prestowitz's help and took his case to the U.S. government, then in the process of negotiating a trade deal with the Koreans. Our government told Khandros, however, that it had more important issues with Korea. But a senior Commerce Department official had a consolation idea -- Khandros could cut costs by moving his own production to Asia!

With government help like this, it's a small wonder that U.S. firms just make their own deals with predatory states and move offshore. With the exception of intellectual-property thefts, trade law stipulates that a manufacturer who is the victim of foreign subsidy, or dumping, or coercive terms of market access, has no direct legal remedy. Rather, the plaintiff files a complaint with a body called the U.S. International Trade Commission. The USITC makes a fact-finding and recommendation, but then it is up to the president to decide whether to retaliate. Invariably, the State Department and the Pentagon have other fish to fry with nations as diplomatically important as China, Japan, Korea, Brazil, or Germany. Cases in which our government grants a remedy, such as imposing a tariff, are the exceptions, but such scattershot remedies against dumping are no substitute for reform of the whole trading system or for a U.S. decision to adopt an industrial policy of its own.

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In this fashion, we are losing industry after industry. The ranks of the companies that behave like patriots have dwindled. Most big multinationals are now too cozy with foreign mercantilists to put up much of a fuss anymore. It has fallen to smaller companies, trade unions, and a few large firms still committed to producing domestically, such as Corning and U.S. Steel, to fight to continue production within the U.S.

In the meantime, the promise of an industrial renaissance spearheaded by the Obama administration's investment in green energy or mass transit or high-speed rail or a smart grid is now running up against the hard reality that there are just too many products that we no longer make and too many foreign links in the industrial supply chain. It will not do to have made-in-America mean only the final assembly of rail cars or wind turbines while the engineering and advanced manufacturing reposes abroad. We need a comprehensive industrial strategy to reclaim manufacturing, and a companion trade policy to make sure that foreign producers do not capture advantage by placing thumbs on the scale.

China is surely at one end of the mercantilist spectrum, with its direct government subsidies of local industry and its strategic government carrots and sticks for Western multinationals. Its entire industrial system is a violation of the premise and spirit of open trade. If the Western democracies had a realistic conception of their long-term interest, they would add high tariffs to Chinese goods until China began behaving like a normal commercial nation. The proceeds could be used to rebuild our own industry.

However, there are other nations that practice what can be called a kind of soft mercantilism. And much of what they do is less to be deplored than imitated. The chart opposite lists foreign industrial strategies that are arguably predatory and compares them with other tactics that could be considered legitimate tools of development. Some of the practices, such as China's use of artificially cheap capital and outright subsidies to develop new industries, could be considered legitimate domestic development tools but predatory in the context of trade. Tariffs could be fairly imposed to offset the anti-competitive effect on companies that enjoy no such government aid. That would also push China toward increasing its domestic consumption and growth, rather than enabling Beijing to base its development on a beggar-my-neighbor strategy of chronic trade surpluses.

Japan and Korea rank somewhere in the middle of the list. Both countries industrialized by showing government favoritism to domestic industrial groups that were almost impossible for foreign companies to break into. Both showered favored industries with artificially cheap bank and public capital. Both used a thicket of subtle barriers that made it hard for exporters to crash their markets, and Korea maintains selectively high tariffs. Taiwan, generally considered a more market-oriented country, launched its information-technology industry with a state-led program, in which the Taiwanese government acquired the necessary technology through the creation of two government-funded research institutions and presided over a planning process of nominally private firms. Today, this small nation is the world's dominant manufacturer of laptops, motherboards, computer monitors, and a great deal more. According to Dan Breznitz, author of the definitive English-language book on the Taiwan miracle, Innovation and the State, "The decision of the state to focus its attention on building a local supplier network for [multinational corporations], coupled with the way it constructed its capital markets, paved a development path for an IT industry."

A good example of soft economic nationalism is the research and development, industry, and labor subsidies of the European Union and member nations such as Germany and Denmark. Remarkably enough, Germany has the world's highest labor costs in manufacturing and the world's largest manufacturing export surplus relative to gross domestic product. Germany doesn't have a planning czar, but it has a tacit understanding among government, industry, and labor that the whole system works to keep high-end manufacturing in Germany. An elaborate apprenticeship system and a program of wage subsidies helps assure the high productivity of German workers in return for their high wages. The German federal government and state governments also have subsidized the creation of new, green industries and used regulatory policy to create domestic demand for their products. Some free-trade purists would argue that subsidizing workers is a covert form of subsidizing industry, and they would be right. The policy is sensible nonetheless.

I conclude from all of this that trade policy and industrial policy are inextricably linked; that we need a radically different approach to trade, so that the global trading system has a single set of rules rather than a maze of double standards; and that we need standards to differentiate legitimate development policy from predation, as well as buffers to protect our legitimate interests when other nations pursue predatory policies. And just as we need to drop the fantasy that other nations admire our fantasy of laissez-faire, we need to jettison the delusion that industrial policy doesn't work. Judging by the success of Japan, Korea, China, Brazil, Taiwan, and the U.S. at an earlier stage of our history, it works just fine. All that remains to accomplish this is to wrest control of policy-making from Wall Street, so that Main Street can have healthy industries once more.

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