Trump’s phase one trade deal with China could strengthen free trade globally

President Donald Trump’s phase one deal could move the world closer to free trade and ultimately save the World Trade Organization.

To academics, free trade is a compelling idea. Virtually every Econ 101 class teaches some variant of David Ricardo’s example of England and Portugal becoming richer by exchanging cloth and wine.

American exports are more technology-intense and exhibit at least 10% greater labor productivity than import-competing industries. Exporting $2.5 trillion and importing a like amount raises U.S. gross domestic product by some $275 billion if trade is balanced and workers displaced by imports find other employment. And specialization instigates a virtuous cycle of dynamic growth by financing larger research and development budgets.

The WTO was set up by Western market economies to similarly encourage specialization for all participants by reducing tariffs and eliminating most quotas.

As tariffs and quotas came down, the WTO focused on other national policies favoring domestic goods and services over imports—for example, preferences to local businesses in government procurement, state subsidies to auto companies to build factories, and the proposed taxes on big tech companies in the U.K., France and Italy, which could advantage European firms looking to compete with U.S. giants like Amazon AMZN, -2.65% , Alphabet GOOG, -2.18%  and MSFT, -3.16% 

When special incentives for Amazon to locate HQ2 in Arlington, Va., only affect domestic competition and when those truly inhibit international commerce, for example, is hardly as clear cut as the gains from trade and losses imposed by tariffs and subsidies on university blackboards.

The major market economies established within the WTO a dispute-settlement mechanism to decide. First a panel of neutral trade experts — generally lawyers and other trade specialists — hear, for example, Boeing’s BA, -1.75% claim that Airbus EADSY, -0.92% gets benefits from the EU that compromise its international sales. If either party doesn’t like the panel’s decision, an appellate body reviews the case.

When parties to a dispute, panelists and judges are from market economies, the system works reasonably well. My career studying these kinds of disputes indicates the United States usually gets a fair shake.

When China, with its socialist-market economy, joined the WTO all that went out the window. It engages in opaque practices to manage its economy that limit imports and boost exports far beyond what Western governments with advanced economies could entertain.

Those include various bureaucratic barriers to imports, subsidies to domestic production, forced technology transfers from foreign companies seeking to access Chinese markets and even state-sponsored industrial espionage. Even persuading scientists at U.S. prestigious universities like Harvard to secretly moonlight for Chinese institutions to spirit away American technology.

Those kind of practices are extraordinarily difficult to police under WTO rules established essentially for market economies, and Chinese participation in the dispute settlement process frustrated efforts to do so. The result for the United States is a huge trade deficit with China that steals many higher paying jobs and stifles the benefits from free trade.

Trump, like Presidents George W. Bush and Barack Obama before him, spent his first year trying to persuade President Xi Jinping to open up China. However, those kinds of practices are central to maintaining state-owned enterprises and Chinese Communist Party guidance to private firms, which it considers essential to a successful socialist-market economy.

Trump resorted to two tactics. Blocking the appointment of new appellate judges at the WTO — the system now has too few to function — and imposing high tariffs on China to make it yield.

China refused but to keep Trump from escalating, it agreed to increase purchases from the United States by $200 billion over two years and limited reforms, which should recoup some of the damage to the U.S. economy. And China accepts a separate bilateral process for Sino-American trade disputes.

This is not pretty, but the alternative was to decouple from China altogether—for example, by imposing new restrictions on Chinese investment in the United States and financial sanctions. That would be a lot worse.

This deal provides a template for the EU and other nations to negotiate with China, and together Western nations can continue to settle their disputes through first-level panels at the WTO—that is similar but stronger than the panel system that preceded the WTO in the General Agreements on Tariffs and Trade.

Hopefully, the next president and U.S. trade representative won’t be so hostile to the WTO and accede to some reforms and new judges for its appellate body.

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