, , , , , , ,

Decoupling” is a word that’s started to pervade news reports and commentary about the U.S.-China trade war. And it’s even at long last been mentioned as a possible goal by President Trump. So this seems like a good time to explain what it really means, and why it’s strongly in both American economic and security interests.

Simply put, decoupling refers to the idea (which I’ve strongly endorsed) that the United States should start disengaging from the Chinese economy. It’s based on the conviction that the closer bilateral commercial ties that have developed between the two countries since China’s economic reform efforts began in the mid-1980s – and that have been avidly sought by U.S. Presidents and lawmakers from both major political parties – have backfired disastrously. They’ve not only greatly strengthened the military power of an increasingly belligerent dictatorship. They’ve also needlessly damaged America’s domestic “real economy” (the businesses and their employees that produce everyday goods and services in the United States – as opposed to the fortunes of the multinational corporations that make goods in China, and of the American financial sector).

In addition, as I’ve explained, major economists have written (albeit in veiled terms) that the grossly lopsided nature of U.S.-China trade and consequently capital flows helped set the stage for the near-global economic meltdown experienced in 2007 and 2008, and the ensuing worst economic downturn suffered by Americans since the Great Depression of the 1930s.

Of course, it would be great if Washington and Beijing could reach a trade deal that solved all these problems, or even greatly mitigated them. But as I’ve also explained, verification problems render this goal impossible. China’s record of violating agreements is simply too long, and its government (including the state-owned and controlled entities that dominate China’s economy) is simply too big and too secretive to warrant any realistic hope that Chinese compliance could be monitored effectively.

So since decades of experience now demonstrate overall that mutually beneficial trade and investment with China simply isn’t possible – at least under this regime in Beijing – the only logical alternative is to start loosening ties. Just as important, as I’ve documented, decoupling has already begun and proceeded to a noteworthy extent.

As a result, the questions before American leaders now entail how much further such disengagement should continue, where it should be actively encouraged, and where – if any place – American policy should try to slow it down or at least try to preserve the status quo.

One of the big arguments against decoupling holds that American businesses (and their employers) can’t afford to deemphasize China because its own domestic market has become so enormous, and because growth potential remains considerable. A related point: China boasts manufacturing strengths for which companies that produce in China for its own or foreign markets (including America’s) simply can’t find adequate substitutes.

But these claims overlook some crucial realities about U.S.-China trade. For example, few U.S.-based businesses export from the United States to the Chinese consumer market. After all, it’s been decades since consumer goods have represented domestic U.S. manufacturing’s strong point, and those firms that remain prominent in the field have long been supplying the Chinese market mainly from China itself.

Moreover, other major exceptions to this rule (like Boeing wide-body airliners, and advanced semiconductors) sell the Chinese products China simply can’t yet make itself. That’s why such aircraft haven’t been tariff-ed by Beijing – and won’t be for the foreseeable future. And even though the Chinese could in principle replace their Boeing purchases by buying from Europe’s Airbus, the result would be complete Chinese dependence on a single source for this crucial product – a situation China rightly seems determined to avoid.

Motor vehicles, interestingly, are another major American consumer export to China – and the PRC is now the world’s largest automotive market as well as the top customer for General Motors and the second biggest for Ford in terms of vehicles sold. But if you look at these firms’ financial statements, you see that the former makes little money in China, and Ford is actually operating at a loss.

Just as important, U.S. and other foreign automotive manufacturers urgently need to come to grips with China’s ultimate intentions – not to remain dependent on non-Chinese products and services one moment longer than necessary. That’s why China remains such a huge extorter and outright thief of intellectual property. Its national business model is to welcome foreign capital in sectors where China has an inadequate presence, use the funds to create one, strong-arm or steal the knowhow to get up to foreign standards, and then spit out non-Chinese firms ASAP.

And China’s apparent rationale (so far) has looked completely reasonable. The country represents one-sixth of humanity, it’s full of smart people. Why should it rely on foreign supplies of anything longer than necessary? Even better – foreign firms and governments, including pre-Trump America’s have seemed all too willing to help out.

As for the tech companies, national security now clearly means that the United States can no longer afford to enable them to supply Chinese entities like telecoms giant Huawei with the chips needed to run their systems. So it’s time to tighten their ties with leading non-Chinese competitors like Nokia and Ericsson, and over the longer term, pitch in and make sure that there’s a major U.S. presence in such internet and global communications markets once again.

Moreover, no one should be deterred by warnings that such decoupling would fracture the global internet. China’s censorship and privacy-threatening practices have already made that outcome inevitable – at least if American leaders take free speech and privacy concerns seriously. And if other countries want to cast their lot with the Chinese, and expose their populations to these Chinese threats, good riddance and good luck to them. They were never likely to be reliable customers for U.S.-based companies anyway.

It’s also necessary to debunk the anti-decoupling claim that the tech companies, and especially the semiconductor manufacturers, earn most of their global profits in China, and as a result would face disaster if much more decoupling takes place. The basis of this claim is the outsized share of their global profits these firms book in China. But an accounting illusion is at work here.

The tech firms book profits in China whenever they sell a computer chip (often assembled, packaged, and tested in China) other product to a China-based assembly plant for computers or smartphones, etc. And the scale of these recorded profits results of course from China’s current dominance of global electronics product assembly. But in a large percentage of cases, the final demand for these goods isn’t China – it’s overseas. And much of that demand of course is American. That’s why more than half of the semiconductors China buys from overseas (including from U.S.-based facilities) get re-exported as parts of final products.

Clearly, the Chinese themselves buy lots of these consumer electronics, too. But their importance is just as clearly overestimated, and as long as firms like Intel and Qualcomm keep making products the Chinese can’t match, their China-based so-called back end semiconductor operations should remain viable.  In that vein, they’d have better odds of preserving their competitive positions if they stopped voluntarily transferring technology and even investing in Chinese-owned tech entities. And even if Mr. Trump’s tariffs help shift much electronics assembly out of China, those operations will still need U.S.-brand insides.

The anti-decouplers are right to argue that both U.S. consumers and businesses still rely on huge flows of low-cost imports of China to help stretch their paychecks and to maintain their global competitiveness. But although China’s ability to produce shoes and toys and clothing and consumer electronics remains peerless, and will not be duplicated easily or immediately elsewhere, that’s no reason to believe that China’s advantages will endure indefinitely.

As widely reported, companies in these industries are already leaving, or planning to leave, China in substantial numbers. Yes, bottlenecks have emerged in alternative production platforms like Vietnam. But if what most Americans believe about economics is true, the new demand will create its own supply – and the businesses involved will have plenty of incentive to make the shifts as quickly as possible.

Even better, decoupling could help Americans solve the pressing problems they face from the economic woes of their hemispheric neighbors. As I’ve written, flows of illegal aliens and drugs could be staunched if the United States prioritized regionalizing its trade arrangements and overhauling the North American Free Trade Agreement (NAFTA) even further to turn North America (including Central America) into a trade bloc – thereby fostering more job creation, development, and prosperity generally.

The role played by Chinese parts, components, and materials in American domestic manufacturing, meanwhile, has been seriously misunderstood. First, since many of these products are fairly capital- and technology-intensive, they’re goods in which domestic producers should be fully competitive, and would be but for massive Chinese government subsidies that depress the China price. Offsetting these subsidies with trade curbs, therefore, would create a huge new opportunity to supercharge domestic American manufacturing and employment.

Second, there’s evidence that the widespread use of these Chinese intermediates is exacting a big long-term cost on U.S.-based manufacturing, by knee-capping its productivity growth. For as I’ve shown, the productivity data indicate that the widespread availability of these artificially cheap products has undermined domestic firms’ incentives to increase their efficiency by developing new and better products and especially processes.

Finally, Chinese direct investment plays a similarly distorting role in the American economy by permitting the presence of government-owned or controlled entities that simply aren’t responsive to pricing signals. If Americans really believe that markets, and their entire economy, work best when participants enjoy the maximum freedom to discover prices and thereby create the optimal terms for competition, a big Chinese footprint is the last thing they should want. And because the United States is having no problem creating its own capital or attracting it elsewhere from abroad, this Chinese presence clearly isn’t needed. It should, additionally, go without saying that any Chinese investment in any U.S. tech or advanced manufacturing companies should be verboten for national security reasons alone.

None of this is to say that U.S.-China decoupling can or should be complete. In fact, the success of Starbucks and, more recently, Costco in China indicate that American consumer companies will continue doing well in the PRC as long as they maintain strong brands (although a Chinese rival is challenging the former). And short-term costs are inevitable when disruption of an immense bilateral economic relationship is on the table. 

But the verdict has long been in: Greater U.S. engagement with the Chinese economy has failed on an epic scale for American prosperity and national security. If the United States wants to avoid the ever greater dangers of continuing endlessly down this road, President Trump should treat decoupling as his top China economic policy priority.