Where next for US China trade?

International relations are governed by diplomatic protocols which are agreed upon principles governing trade and other matters. Trade agreements are, in general, mutual in nature. A country which unilaterally alters a trading relationship breaches the mutuality principle. In most cases there would be dispute resolution mechanisms, such as the World Trade Organisation, whose jurisdiction both countries would agree to respect.

However, where one side won’t accept third party jurisdiction then it can come down to a game of bluff and counter-bluff and it would depend on the balance of power in the relationship as to the terms upon which it is resolved. This is the situation in which the current dispute between the US and China finds itself so it is instructive to look at where the balance in the trading relationship lies.

The root cause of the dispute is the large (US$350bn) trade deficit which the US runs with China and which it would like to reduce. However, given that trade agreements are mutual, it is not clear that any possible new accord can affect the imbalance. China is the workshop of the world, par excellence, and is competitive in significant portions of the supply chains of many products; for example, without China smartphones would be considerably more expensive and, in consequence, their adoption much less widespread.

China has achieved this position as a result of policies pursued over many decades based on keeping it’s labour costs internationally competitive, upskilling it’s workforce, investing in infrastructure to improve efficiency, vertical integration of industries to capture as high a share of the manufacturing process as possible, etc.

The US, by contrast, has been moving in the opposite direction over the same period. Companies were encouraged to outsource production to lower cost locations; whereas initially this affected only low end processes it has since broadened to cover most of the supply chain. The US has retained it’s international competitiveness in high end and specialised niches but much of it’s mid level manufacturing struggles to stay competitive. The US has neglected infrastructure investment and allowed it’s medical and legal costs to get out of control which further discourages manufacturing investment.

Let’s take digital photography as an example. Such products are found in cameras, smartphones, tablets, webcams, drones, security devices etc. Demand for these products follows a given growth trajectory and will continue to do so. Whereas much of the science and software in this sector originates in the US almost all of the manufacturing is in Asia (with most in China). What then would cause manufacturing in digital photography to reshore to the US? Or, to put it another way, how will the US China trade war affect the decisions of companies in this sector regarding where to manufacture.

In my view the trade war won’t make any difference to where companies choose to locate their manufacturing as China’s advantages in this area are too deeply embedded. The trade war, thus, means little more than a consumption tax in the US with negative consequences for the sectors targeted by China’s retaliatory countermeasures. If the US wants to win it must go back to basics and address the underlying causes of it’s manufacturing uncompetitiveness:

1. Health Care: The US spends about twice as much as other wealthy countries but with worse outcomes.
    
2. Legal system: The US spends about 2% of GDP on legal fees whereas countries such as Japan are able to manage at about a tenth of that level. Also the insurance sector absorbs more resources than in countries with coded  as opposed to common law legal systems.
    
3. Executive compensation: Quoted companies incentivise executives to maximise profits in the short term often to the detriment of long term investment.
    
4. Infrastructure: The US continues to lag in investment; for example, high speed rail in California has been debated for decades but work has yet to commence whereas China’s completes that length of track every six months.
    
5. Urban Planning: Low density housing in city surburbs is wasteful of resources compared with high density housing.

Given the principles of mutuality and reciprocity it is not clear what concessions China could make in any trade negotiations that would materially reduce the deficit. For the US, starting a trade war to cast the blame onto another country may, in the short term, create the impression that something is being done but, in reality, does little to address the underlying causes of manufacturing uncompetitiveness and merely kicks the can down the road.