Policy, Tariffs, and Trade 3 -- China Shock 1

2024 04 14

Internet panics come and go with such speed. Just a few months ago, people were worried—some genuinely, others with perhaps a hint of crocodile tears—about China's real estate crisis, fearing a potential recession or worse. I addressed this concern unsympathetically in a previous post:

[https://thomaslhutcheson.substack.com/p/china-needs-more-consumption]

But now, the focus has shifted.

Recently, there's growing concern that China, far from succumbing to recession, might dodge it altogether by dramatically increasing its exports of manufactured goods. Although posed as, “will it be enough,” the worry isn't just about whether this pivot will be effective in the short or long term; it's about the type of products China will export. There's a fear that China will flood the market with sophisticated goods like electric vehicles ([https://www.ft.com/content/ae517907-0244-4344-ad0a-1d029c03555b?shareType=nongift)—a shift that could trigger a second "China Shock."

But before delving into the possibility of a "China Shock II," let's take a step back and revisit the original China Shock. What exactly was it, and why was it so "shocking"?

Understanding the China Shock

The China Shock was the sudden emergence of China as a major player in the global economy. It stemmed from a fundamental decision by the Chinese Communist Party to transition from a highly centralized planned economy to a more capitalistic one, rom virtual isolation from the world economy to a full participant. This transition led to a significant increase in China's ability to supply of manufactured goods, coinciding with a period of rapid decline in the costs of international shipping and telecommunications.

The impact of the China Shock was felt worldwide, but perhaps nowhere more profoundly than in the United States. As the largest economy affected by China's policy shift and changes in global transportation and communication, the U.S. response is of particular interest, especially as the US response was a model for other countries as well.

Effects on the US

To understand the effects of the China Shock on the U.S., we can turn to conventional trade theory, specifically the Stolper Samuelson theorem.[1] This theorem suggests that a decrease in the price of low-wage manufactured goods leads to a reduction in real wages for workers producing those goods in the importing country. While there are gains from trade in the importing country overall, the distribution of these gains is uneven.  And to reiterate, this does not suppose any policy change by the US.

Although the Stolper[2] Samuelson theorem was well accepted among trade economists, traditionally, the impact of international trade on U.S. workers was thought to be minimal, given the relatively small number of workers directly competing with imported goods. Trade was and still is a fairly small part of US GDP and it was thought that a large part of the gains from trade would be captured by workers in import-competing activities becoming employed in other sectors including exporting sectors.

However, the sheer scale of China's increase in supply challenged this assumption. With Chinese GDP and manufactured exports growing at unprecedented rates, the dynamics shifted.

Second the ability of workers to shift from activities that competed with imports from China to other activities depends on the trade balance remaining basically unchanged.  Greater supply of imports would drive down the exchange rate, quantities imported would be reduced and quantities exported rise and the trade balance would remain unchanged. 

For more background on how things are supposed to work and why they sometimes do not, see:
https://thomaslhutcheson.substack.com/p/policy-tariffs-and-trade  

and

https://thomaslhutcheson.substack.com/p/policy-tariffs-and-trade-2

Macroeconomics

But here macroeconomics in the 2000’s got in the way of this shift of workers.  After 2001 the US began running large structural deficits which through Fed actions raised US interest rates and made the US more attractive for short term international capital – including from China.  The inflow of foreign financial capital in turn, drove _up_ the exchange rate offsetting and indeed inhibiting the shift of workers in import competing sectors to other activities. 

I would add that the Fed during this period was a LOT more focused on keeping inflation low than in promoting employment and growth, which would also have made the shift more difficult when the China Shock (like any other extraordinary shock) would call for above-target inflation to facilitate adjustment.

[See: https://thomaslhutcheson.substack.com/p/framework-for-monetary-policy-1] 

And let’s not forget the elephant in the room, the abysmal response of the Fed to the 2008 financial crisis, its refusal to maintain its inflation target in much of 2009-2020 even when unemployment was high.   Years of low inflation and slow real growth are the worst time to expect workers to shift to new activities.

Trade Policy

So far, I have not mentioned US trade policy and that is intentional.  In my opinion the other factors: Chinese openness policy, improved transportation and communications technology and US fiscal policy were far more important for explaining the China Shock that trade policy.  But trade policy did have some effects.  For one thing US support for China’ entering the World Trade Organization (and as a “developing” country with fewer obligations to liberalize its own imports) facilitated the China’s strategy of attracting foreign investment to increase, inter alia, its manufactured exports.  Investors felt less risk that their investments in China would be thwarted by new import restrictions in developed countries or exports from developed countries to China.

For another, US negotiators whether at the WTO or regionally tended to prioritize gaining access for US intellectual property services over gaining access for goods exports.  Together these trade policies reinforced the other tendencies in concentrating the costs of the China Shock on middle-sophistication manufacturing which is predominately in the US Midwest and the benefits on service producing coasts.[3] Readers may speculate for themselves about the effect of the uneven distribution of benefits and costs on US politics.              

With this context in mind, we're better equipped to contemplate the possibility of a China Shock 2 and consider appropriate responses.

Stay tuned.

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[1] https://en.wikipedia.org/wiki/Stolper%E2%80%93Samuelson_theorem

[2] A personal note.  Stolper was a professor at University of Michigan in the late ‘60’s when I was working on my PhD.  By that time however he was more focused on economic development, particularly of the at the time recently independent Nigeria.  I never heard him reference the accomplishment for which he was most famous. 

[3] Midwestern agriculture was also affected by macroeconomic and trade policy priorities, but the US has such a strong comparative advantage in agriculture that it was, if anything, positively affected by the China Shock. 

[Standard bleg:  Although my style is know-it-all-ism, I do sometime entertain the thought that, here and there, I might be mistaken on some minor detail.  I would welcome comments on these views.]