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Trade war: For countries like China, the free lunch is now history

In his 1997 article in the Journal of Economic Literature, Paul Krugman famously stated that “The economist's case for free trade is essentially a unilateral case: a country serves its own interests by pursuing free trade regardless of what other countries may do.” This statement has become a kind of rallying cry for those opposed to the trade war initiated by the current US administration; proof that the trade war will hurt American interests in the long term.

And though Mr. Krugman, a winner of the Nobel Prize for Economics chooses to stand by this statement, the trade environment in which this statement was originally made was an innocent one. It was an age when most participants complied with the rules of fair play that were established through practice rather than regulation. An environment which preceded China’s entry into the trade arena and its weaponization of trade.

To a very large extent, it was Japan which was the original offender in this regard. Many of the tactics China uses were tested successfully by Japan, albeit on a much smaller scale.

Normally, when trade is conducted without state intervention, if Country A has an export surplus with Country B, Country A’s currency will appreciate against that of Country B. This appreciation will make Country A’s products more expensive in Country B and make Country B’s products cheaper in Country A. Over time, this will ensure that demand for Country B’s products rises and that for Country A’s falls, restoring trade balance.

However, this works only till such time that trade partners stay away from state intervention in the currency markets. Continuing with the above example, if Country A starts intervening in its currency market to create an artificial demand for Country B’s currency, its own currency will not appreciate. As a result, the competitive advantage that it enjoys over Country B is perpetuated and so is the trade imbalance. As the demand for Country A’s goods remains unfairly elevated, jobs are created in Country A and lost in Country B on a sustained basis.

Japan discovered this flaw in the self-correcting process and leveraged it to perpetuate its favorable imbalance, enriching its citizens before hitting its demographic limits. While the impact on Japan’s economy was extremely salutary, its impact on the US was muted because of the relative size of their population. China’s size made it a completely different animal and its demographic limits are quite a distance away.

Contrary to popular belief, China’s entry into global trade did not begin when it acceded to the World Trade Organization (WTO) in December 2001. Data of China’s exports to the US, which is available from 1985, shows that accession to the WTO was after many years of trade participation and growth. It was a time that saw Chinese trade surplus with the US growing from $6 million (not a typo) in 1985 to $83 billion in 2001.

However, in the 6 years that followed this accession, it was as if all logical constraints disappeared. The US trade deficit with China grew at an average rate of 21 per cent to more than triple to $259 bn before slowing for the 2008 crisis (all data from FRED). It stands at 420 bn for 2018 but looks set to drop by as much as 15 per cent in 2019 as the impact of the trade war sets in.

To analyze the impact of this manipulative trade behavior on jobs in the US, an analysis of how the relationship between US GDP and the number of people employed by the manufacturing sector changes in these three time periods (before 1985, 1985 to 2001 and after 2001) is instructive (See chart).

An economy which steadily added jobs as it grew before the 1980s, experienced an extended period of jobless growth starting in the early 1980s to the turn of the millennium. Then for a decade, even as the economy continued to grow, jobs stared to shrink.

This is also apparent from an analysis of the correlation between the two series. The decadal correlation between US GDP and US manufacturing jobs, which averaged 0.56 between 1948 and 1984 dropped to -0.18 between 1985 and 2001 before collapsing to -0.67 between 2002 and 2016. It was only in 2018 that it rose to 0.95, the 5th highest since 1948 and in the midst of the trade war.

Another phenomenon that one can observe from the chart is that through the years, while manufacturing jobs were lost during slowdowns and recessions, an increase in these was visible in the years that followed.

The exception to this is the aftermath of the 2001 recession which coincided with Chinese accession to the WTO. Deep job losses from this recession were never recovered as China twisted the facilities available in the WTO and combined it with the US’s openness to capital flows to gain a persistent trade advantage.

This sustained advantage resulted in unskilled jobs, typical of those available in manufacturing especially in a machine assisted environment, being lost in the US and gained in China. In the frictionless and perfectly rational world that economists restrict their beliefs to, unskilled workers upskill and reskill when they lose their jobs, gaining the skills necessary to remain employable. Reality, however, is very different.  

As such, to state unequivocally that a nation benefits from trade, regardless of what its partners do is not only misguided but borders on the fallacious. It ignores the finer impact of trade at a more granular level, choosing instead to remain content with analysis that is restricted to aggregates and averages. An economy bears the burden of providing for all. It is now clear that globalisation didn’t serve the interests of those at the bottom of the US income pyramid.

As the globalisation pendulum swings the other way, protectionism is increasingly accepted as the new normal. And while this, as with the reverse, will also change over time, it is almost certain that no country will be allowed to “game” the system to gain an unfair and sustained advantage. Global trade will recover eventually, but it will only be on the back of meaningful changes on how countries like China are required to change their behavior to continue participating. The free lunch for them is over.

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