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Scott Powell / March 12, 2019

Edging Closer to a Trade Deal

The United States and China are edging closer to finalizing a trade deal that should end the tariff penalties that are at the heart of a year-old trade war.

The United States and China are edging closer to finalizing a trade deal that should end the tariff penalties that are at the heart of a year-old trade war.

It’s also hoped that the deal will include enforcement and penalties for China’s national security-related intellectual property (IP) theft and espionage, and provide structural changes that would end forced technology transfer and protect trade secrets and intellectual property rights of American companies doing business in China.

Tariff problems trace back to 2001, when China joined the World Trade Organization (WTO). At that time, China was granted “developing country” status by the WTO, which allowed it to nurture infant industries by levying high tariffs on imports from the United States and Europe even while China benefited from low tariffs on its exports into those same countries.

Now that China’s economy is the second largest in the world after the United States, having increased its GDP nearly 10-fold since 2001, there is precedent for China to adopt tariff rates in line with the lower rates characteristic of the United States and its other primary trading partners. This was the path taken by South Korea and other Asian tigers once their export-led policies delivered high economic growth and lifted their people out of poverty.

The protection and enforcement of intellectual property and trade secrets of American companies doing business in China is thornier than solving tariff rate differentials. Fortunately, when China joined the WTO, it agreed to comprehensive language and mechanisms regarding the enforcement of IP rights, which was established by the Trips Agreement in the Uruguay Round of 1989-1990.

As a member of the WTO, China is required to conform to WTO protocols and legal framework of resolution and remedies for settling IP disputes. The limitations of the Trump administration’s current bilateral negotiations to resolve American companies being forced to transfer their IP technology as a condition to doing business in China can also be effectively advanced by multi-lateral pressure from OECD trading partners in the WTO.

Getting to yes with China even when we achieve less than what is optimal can be more easily swallowed when we take the long view of David Ricardo’s theory of comparative advantage, which remains as applicable today as when it was first recognized in 1817. Comparative advantage reminds us that all nations benefit from trade by producing and exporting products and services in which their advantage is greatest or their disadvantage is least.

The understanding of comparative advantage has become broader and more nuanced in the last 50 years thanks to economists who expanded the understanding of total factor productivity (TFP). TFP is the residual in the production function equation that’s not attributable to quantitative linear variables of capital stock and labor output. It first focused primarily on the education and specialized knowledge of the workforce and the state of the technological advancement of the workplace.

But more recently, TFP has been enlarged to include political, social, legal and regulatory variables at the national level — that include factors such as the ease of business formation, efficiency of capital markets, macroeconomic stability, respect for rule of law, property rights, free expression, as well as the institutionalization of competition, transparency and accountability.

While China has recently surpassed the United States on total patents granted and is moving upstream in artificial intelligence and other technological development, its TFP is a shadow of what we enjoy in the United States. China’s primary comparative advantage remains large-scale cheap labor suited for low tech consumer product O.E.M. manufacturing. America’s comparative advantages are many and include being world leader in high tech innovation and manufacturing; having 6 of the 10 top universities in the world, and 8 out of the 10 most valuable brand names in the world.

Countries with high TFP are all at the top of the Index of Economic Freedom. They enjoy greater prosperity because of the aforementioned contributing factors and institutions that enable the free market to thrive with innovation that provides solutions to old and new problems. High TFP is also tightly correlated with healthier societies and cleaner environments — two essential measures of welfare.

It’s all but certain that this trade deal will deliver significant tariff reductions with attendant benefits to both sides. We should be less sanguine in our expectations for this agreement to solve the majority of our problems with China in the protection of U.S. trade secrets and intellectual property rights. And so long as China denies involvement in national security-related technology theft and espionage, progress in addressing those problems will be elusive.

The good news is that if we keep the long view — making incremental success in subsequent trade negotiations with the help of the WTO — while avoiding protectionism, vigilantly protecting and nurturing all elements of our total factor productivity advantage, and following the essential requirements of comparative advantage in trade, America’s future will likely be as bright as the past.

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