A decentralized look at the U.S.-China trade war

For the time being, it is highly unlikely that the Trade war between Beijing and Washington will be resolved. In May 2019, Trump increased tariffs on Chinese commodities (worth $200 billion) from 10% to a whopping 25%. So far, the US has imposed tariffs worth about $250 billion on China, while China has retaliated with tariffs on US goods estimated at well over $100 billion.

It would be pertinent to point out that trade disputes have not been restricted only to Washington and Beijing. Imposition of tariffs has been a bone of contention with numerous US allies, including Japan.

Of late, trade issues have resulted in major differences between New Delhi and Washington. Even though there are convergences between both countries on numerous strategic issues, resolving the differences between both sides on trade-related matters is likely to be an onerous responsibility.

In response to tariffs imposed by Washington, New Delhi retaliated, and has imposed tariffs, estimated at $200 million, on 29 commodities (including apples, almonds, and chickpeas). India’s decision was a response to Washington’s decision to impose tariffs, of 10% and 25% on aluminium and steel, in May 2018. Last year, New Delhi refrained from imposing tariffs, but did raise import taxes on a number of US goods to 120% after Washington declined to exempt New Delhi from higher steel and aluminium tariffs. The key propelling factor for India’s recent imposition of tariffs was the US decision to scrap the Generalized System of Preferences (GSP) for India from June 5, 2019. India benefited immensely from this scheme, as it allowed duty-free exports of up to $5.6 billion from the country.

Pressure on Trump

Even though no solution is in sight, there are a number of lobbies in the US, especially trade groups and US businesses, which have been repeatedly urging the Trump Administration to find a solution to the current impasse with China.

Only recently for instance, 600 companies, including Walmart, in a letter to the U.S. President, urged him to resolve trade disputes with China, stating that tariffs were detrimental to the interests of American businesses and consumers. The letter was sent as part of the ‘Tariffs Hurt the Heartland’ campaign.

To underscore the detrimental impact of trade wars on the American economy some important estimates were provided. The letter stated that tariffs of up to 25% on $300 billion worth of goods could lead to the loss of two million jobs. Costs for an average American family of 4 would also increase an estimated $2000 if such tariffs were to be imposed.

Reports indicating the challenges to the US economy and FDI from Chinese companies in US

A number of surveys and reports illustrate the profound challenges which the US economy is facing, as well as a drop in FDI from China.

The University of Michigan’s consumer sentiment index also revealed a drop in consumer sentiment from 100 in May to 97.9 in June. This was attributed to trade wars between China and the US.

According to a survey released by the China General Chamber of Commerce USA, investment by Chinese companies in the United States has witnessed a significant decline since 2016 (including a sharp drop in 2018 and early 2019).

A number of important events have been held recently, where efforts were made to draw more Chinese investments to the US. One such event was the Select USA Summit. Speaking at the Summit, US Commerce Secretary Wilbur Ross stated:

We welcome investment from any place as long as it’s investment that poses no challenges for national security.

US states and FDI

What was clearly visible at the Select USA Summit was the fact that a number of US states pitched for expanding economic ties with China, and drawing greater Foreign Direct Investment.

The state of North Carolina sought to attract investments in areas like IT, aviation, and biotech. The US headquarters of Lenovo are in the state of North Carolina. Trump’s trade wars have hit the state in a big way, and one of the sufferers has been soy bean farmers. As a result of a 25 percent imposition of tariffs, the price of a bushel of soy beans has dropped to $8, from $10 in 2018.

Other US states brought to the fore the impact of tariffs on their respective economies. According to a senior official from the state of Louisiana for instance, it has suffered immensely as a consequence of the imposition of tariffs. Agricultural commodities from Middle America to China are imported through export terminals in Louisiana. Don Pierson, the senior official from Louisiana, said that the agricultural economy of the state, as well as the logistics economy of the state, have taken a hard hit as a consequence of the trade wars. Pierson also spoke about the possibility of exporting LNG from Louisiana to China. Chinese companies in the state of Louisiana, which include Yuhuang Chemical Group (Shandong’s), have made major investments. Shangdong’s decided to invest $1.85 billion in a methanol production complex (this was one of the largest Chinese direct investments in US). Wanhua Chemical Group invested over $1 billion (1.2) in a chemical manufacturing complex in southeastern Louisiana.

A number of Chinese companies have also begun to realise that there is need to adopt a nuanced approach, and are still tapping certain US states for investment.

Another important event was the Select LA Summit. The Los Angeles Mayor Eric Garcetti, and Lenny Mendonca, chief economic adviser to the California governor, assured overseas investors of all possible support from the town of LA, as well as the state of California.

Impact of trade disputes and Washington’s stance vis-à-vis Huawei

US states and Chinese provinces have been at the forefront of improving economic ties between both countries. Both are likely to suffer as a consequence of not just the trade war between both countries, but also the US ban on Huawei. The tech company, according to a report published in 2016, contributes 7% of the GDP of the town of Shenzhen (Guangdong province). Affiliates of Huawei provide employment to an estimated 80,000 people, while a research facility in a nearby city of Dongguan, provides employment to well over 3,000.

Conclusion

In conclusion, it is important for all stakeholders, not just businesses from both countries, to play their role in resolving economic and technological disputes between China and the US. It is also important for Chinese provinces as well as US states to play a pro-active role in reducing tensions. Both governments, while realising the importance of federating units, have set up official dialogues and set up other mechanisms for sub-national exchanges. It is important that these platforms now contribute towards reducing the divergences between both countries. While all eyes are on the political leadership of both countries, it is important to realise that the stakeholders in the US-China relationship are not restricted to Beijing and Washington DC.

Nightcap

  1. Lake Wobegon’s Ghost Churches Rod Dreher, The American Conservative
  2. The Russian affinity for American stuff continues unabated Guy Archer, Moscow Times
  3. Avoiding World War III in Asia Parag Khanna, National Interest
  4. Did government decentralization cause China’s economic miracle? Hongbin Cai, World Politics

An update on the federalist debate in India

In recent days, numerous leaders in India’s South have spoken in one voice against the 15th Finance Commission — arguing that it is unfair to South Indian states. The bone of contention is a directive in the terms of reference given to the Finance Commission, which states that the distribution of revenues amongst states should be based on the 2011 census, as opposed to the 1971 census. During this period, South Indian states have fared well in controlling their population, while Bihar, Uttar Pradesh, Madhya Pradesh, Rajasthan, and Uttar Pradesh – all northern states – have been unsuccessful. South Indian states have put forth the argument that they have been penalized for controlling their population, while states which have not fared particularly well have been rewarded.

Some leaders have also objected to the commission dubbing important welfare schemes as ‘populist’ without understanding the economic and social dynamics of different states.

Non-Economic Issues Continue reading

On why complexity from simple rules is counterintuitive

“… normally we start from whatever behavior we want to get, then try to design a system that will produce it. Yet to do this reliable, we have to restrict ourselves to systems whose behavior we can readily understand and predict–for unless we can foresee how a system will behave, we cannot be sure that the system will do what we want.

“But unlike engineering, nature operates under no such constraint. So there is nothing to stop systmes like those at the end of the previous section from showing up. And in fact one of the important conclusions of this book is that such systems are actually very common in nature.

“But because the only situations in which we are routinely aware both of the underlying rules and overall behavior are ones in which we are building things or doing engineering, we never normally get any intuition about systems like the ones at the end of the previous section.”

Stephen Wolfram

The deeper you dig into math and computer science, the more Hayekian things look. The impossibility of economic calculation under socialism has important counterparts in Godel and Turing/Church.

Some Thoughts on State Capacity

State capacity is an important topic and the subject of much recent attention in both development economics and economic history. Together with Noel Johnson I’ve recently written a survey article on the topic (here). At the same time, many libertarians and classical liberals are uncomfortable with the concept (see here and here). I think these criticisms are useful but misplaced. Addressing them will hopefully move the debate forward in a useful fashion.

Here I will just focus one issue. This is the argument recently made by Alex Salter that state capacity is a black box. Alex notes correctly that we have a detailed and convincing theory for how markets can lead to economic growth (by directing resources to their most efficient use). In contrast, according to Alex:

“State capacity, by itself, addresses neither the information issue nor the incentive issue. While governance institutions obviously began centralizing at the beginning of the modern era, this is just a morphological description of what happened to institutions. On its own, that’s insufficient as a causal explanation”.

I think Alex and other critics are on the wrong track here. State capacity is not alternative explanation for economic growth to that offered by markets. The relevant question is what impeded market development before, say, 1700, and what enabled the growth of markets after around 1700. The evidence provided by a body of research suggests that prior to 1700 market development was impeded by political fragmentation both within and between states. Critics of the state capacity argument should engage with this literature.

A second claim Alex makes is that we lack a theory for why the more centralized states that arose after 1700 were less rent-seeking and predatory than their weaker and more internally fragmented predecessors. But in fact we have a fairly good understanding of many of the mechanisms responsible for the demise of the more costly forms of recent seeking that characterized medieval and early modern Europe. This understanding is based on the work of James Buchanan and Mancur Olson.

The basic argument is this. Medieval and early modern states were mostly devices for rent-extraction and rent-seeking. But this rent-extraction and rent-seeking was largely decentralized. They collected taxes through a variety of costly and inefficient means (such as selling monopolies). They then spent the tax revenue on costly wars.

Decentralized rent-extraction was costly and inefficient. For example, it is well known that weights and measures varied from place to place in preindustrial Europe. What is less well known is that there were institutional reasons for this, as each local lord wanted to use his own measures in order to extract more surplus from the peasants who were forced to grind their grain using his mill. Local cities similarly used their own systems of weights and measures in order to extract surplus from traveling merchants. This benefited each local lord and city authority but imposed a large deadweight loss on the economy at large.

The logic of internal tariffs was similar. Each local lord or city would choose their internal tariffs in order to maximize their own income. But we know from elementary microeconomics that in this setting each local authority will set these tariffs “too high” because they will not take into account the effect of their tax rate on the tax revenue of their neighbors who also set their tariffs too high.

When early modern European rulers invested in state capacity, they sought to abolish or restrict such internal tariffs, to impose uniform taxes, and to standardize weights and measures. This resulted in a reduction in deadweight loss as when the king set the tax rate he considered the tax revenue he gets from his entire realm, and internalized the negative externality mentioned above.  The reasoning is identical to that which states that a single combined monopolist may be preferable to an up-stream and down-stream monopolist. When it comes to a public bad (like rent-seeking) a monopolist is preferable to competition.

Political Decentralization and Innovation in early modern Europe

My full review of Joel Mokyr’s A Culture of Growth is forthcoming in the Independent Review. Unfortunately, it won’t be out until the Winter 2017 issue is released so here is a preview. Specifically, I want to discuss one of the main themes of the book and my review: the role of political decentralization in the onset of economic growth in western Europe.

This argument goes back to Montesquieu and David Hume. It is discussed in detail in my paper “Unified China; Divided Europe’’ (forthcoming in the International Economic Review and available here). But though many writers have argued that fragmentation was key to Europe’s eventual rise, these arguments are often underspecified, fail to explain the relevant mechanisms, or do not discuss counter-examples. Mokyr, however, has an original take on the argument which is worth emphasizing and considering in detail.

Mokyr focuses on how the competitive nature of the European state system provided dynamic incentives for economic growth and development. This argument is different from the classic one, according to which political competition led to fiscal competition, lower taxes, and better protection of property rights (see here). That argument rests on a faulty analogy between competition in the marketplace and competition between states.  The main problem it encounters is that while firms can only attract customers by offering lower prices (lower taxes) or better products (better public goods), states can compete with violence. Far from being competitive, low tax states like the Polish-Lithuanian commonwealth were crushed in the high-pressure competitive environment that characterized early modern Europe. The notion that competition produced low taxes is also falsified by the well-established finding that taxes were much higher in early modern Europe than elsewhere in the world.

It is also not the case that political fragmentation is always and everywhere good for economic development. India was fragmented for much of its history. Medieval Ireland was fragmented into countless chiefdom prior to the English conquest. Perhaps we can distinguish between low-intensity but fragmented state systems which tended not to generate competitive pressure such as medieval Ireland or South-East Asia and high-intensity fragmented state systems such as early modern Europe or warring states China. But even then it is not clear that a highly competitive and fragmented state system will be good for growth. In general, political fragmentation raised barriers to trade and impeded market integration. Moreover a competitive state system means more conflict or more resources spent deterring conflict. For this reason political fragmentation tends to result in wasteful military spending. It can be easily shown, for instance, that a much higher proportion of the population spent their lives in the economically wasteful activity of soldiering in fragmented medieval and early modern Europe than did in either the Roman empire or imperial China (see Ko, Koyama, Sng, 2018).

Innovation and Decentralization

What then is Mokyr’s basis for claiming that political fragmentation was crucial for the onset of modern growth? Essentially, for Mokyr the upside of Europe’s political divisions was dynamic. It was the conjunction of political fragmentation with a thriving trans-European intellectual culture that was crucial for the eventual transition to modern growth. The political divisions of Europe meant that innovative and heretical thinkers had an avenue of escape from oppressive political authorities. This escape valve prevented the ideas and innovations of the Renaissance and Reformation from being crushed after the Counter-Reformation became ascendant in southern Europe after 1600. Giordano Bruno was burned in Rome. But in general heretical and subversive thinkers could escape the Inquisition by judiciously moving across borders.

Political fragmentation enabled thinkers from Descartes and Bayle to Voltaire and Rousseau to flee France. It also allowed Hobbes to escape to Paris during the English Civil War and Locke to wait out the anger of Charles II in the Netherlands. Also important was the fact that the political divisions of Europe also meant that no writer or scientist was dependent on the favor of a single, all powerful monarch. A host of different patrons were available and willing to compete to attract the best talents. Christina of Sweden sponsored Descartes. Charles II hired Hobbes as a mathematics teacher for a while. Leibniz was the adornment of the House of Hanover.

The other important point that Mokyr’s stresses is Europe’s cultural unity and interconnectedness. As I conclude in my review, Mokyr’s argument is that

“the cultural unity of Europe meant that the inventors, innovators, and tinkers in England and the Dutch Republic could build on the advances of the European-wide Scientific Revolution. Europe’s interconnectivity due to the Republic of Letters helped to give rise to a continent-wide Enlightenment Culture. In the British Isles, this met a response from apprentice trained and skilled craftsmen able to tinker with and improve existing technologies.  In contrast, political fragmentation in the medieval Middle East or pre-modern India does not seem to have promoted innovation, whereas the political unity of Qing China produced an elite culture that was conservative and that stifled free thinking”.

It is this greater network connectivity that needs particular emphasize and should be the focus of future research into the intellectual origins of growth in western Europe. At present we can only speculate on its origins. The printing press certainly deserves mention as it was the key innovation that helped the diffusion of ideas. Mokyr also points to the postal system as a crucial institutional development that enabled rapid communication across political boundaries. Other factors include the development of a nascent European identity and what Chris Wickham calls, in his recent book on medieval Europe, “the late medieval public sphere” (Wickham, 2016). These developments were important but understudied complements to the fragmented nature of the European state system so frequently highlighted in the literature.

Geopolitics and Asia’s Little Divergence: State Building in China and Japan After 1850

Crossposted at the Medium

Why did Japan successfully modernize in the 19th century while China failed to do so? Both China and Japan came under increasing threat from the Western powers after 1850. In response, Japan successfully undertook a program of state building and modernization; in China, however, attempts to modernize proved unsuccessful and the power of the central state was fatally weakened. The failure to build a modern state led to China’s so-called lost century while Japan’s success enabled it to become the first non-western country to industrialize. In a paper with Chiaki Moriguchi (Hitotsubashi University) and Tuan-Hwee Sng (NUS), we explore this question using a combination of historical evidence and formal modeling.

On the surface this East Asian “little divergence” is extremely puzzling. Qing China, as late as the end of the eighteenth century, was a powerful centralized empire. An impersonal bureaucracy selected by exams, and routinely rotated, governed the empire. In contrast, the institutions of Tokugawa Japan are usually described as feudal. The shogun directly ruled only 15% of the country. The remainder was divided into 260 domains ruled by lords known as daimyo who collected their own taxes, possessed their own armies, and issued their own currencies. To the outside observer China would have seemed much more likely to have been able to establish the institutions or a centralized state than Japan.

Figure 1: Qing China and Tokugawa Japan

For much of the early modern period (1500–1700) China and Japan possessed military capabilities that made them more than a match for any western power. This changed dramatically after the Industrial Revolution and their vulnerability exposed by the Opium War (1839–1840) and the Black Ships Incident of 1853, respectively. During the First Opium a small number of British ships overpowered the entire Chinese navy, while Commodore Perry’s show of force in landing in Japan in 1853 convinced the Japanese of western naval superiority. Within a few years, political elites in both countries recognized the need to modernize if only to develop the military capacity required to fend off this new danger.

* * *

koyamajapanperry
Figure 2: Commodore Perry in Japanese eyes

In China, after the suppression of the Taiping Rebellion, there were attempts at modernizing — notably the Self-Strengthening movement associated with Li Hongzhang and others. Recent scholarship has reevaluated this movement positively. At the purely military-technological level it was in fact quite successful. The Jiangnan Arsenal and the Fuzhou Shipyard saw the successful importation of western military technology into China and the Chinese were soon producing modern ships and weaponry. However, these developments were associated with a process of political decentralization as local governors took on more and more autonomy. The importation of military technology was not associated with more far-reaching societal or political reforms. There was no serious attempt to modernize the Qing state.

In contrast, Japan, following the Meiji Restoration, embarked on whole scale-societal transformation. The daimyo lost all power. Feudalism was abolished. Compulsory education was introduced as was a nationwide railway system. A new fiscal system was imposed in the teeth of opposition from farmers. The samurai were disarmed and transformed from a military caste into bureaucrats and businessmen.

Qing China and the newly modernized Meiji Japan would collide in the first Sino-Japanese war (1894–1895). Before the war, western observers believed China would win in part because of their superior equipment. But the Chinese lacked a single national army. It was the Beiyang army and the Beiyang fleet that fought the entire Japanese military force. The fact that Japan had undergone a wholesale transformation of society enabled them to marshal the resources to win a rapid victory.

 

koyamabaiyanfleet
Figure 3: The Jingyuan, one of the ships in the Baiyang fleet

* * *

Why did the Japanese succeed in modernizing while Qing China failed to do so? Historians have proposed numerous explanations. In our paper, however, rather than focusing on cultural differences between Japan and China, we focus on how different geopolitical incentives shaped their decisions to invest in state capacity and state centralization.

Before the mid-19th century China only faced a threat from inner Asia from where historically nomadic invasions had routinely invaded and threatened the sedentary population of the Chinese plain. Due to this threat, historically China tended to be a centralized empire with its capital and the bulk of its professional army stationed close to the northern frontier (see Ko, Koyama, and Sng (2018)). In contrast, Japan faced no major geopolitical threats prior to 1850. This meant that it could retain a loose and decentralized political system.

After 1850 both countries faced major threats from several directions. China was threatened on its landward borders by Russian expansionism and from the coast by Britain and France (and later Germany and the United States). Japan was threatened from all directions by western encroachment.

We build a simple model which allows for multidirectional geopolitical threats. We represent each state as a line of variable length. States have to invest in state capacity to defend against external geopolitical threats. Each state can use centralized fiscal institutions or decentralized fiscal institutions.

If there is strong threat from one direction, as China faced prior to 1850, the dominant strategy is political centralization. In the absence of major geopolitical threats decentralization may be preferable as was the case in Tokugawa Japan.

The emergence of a multidirectional threat, however, changes things. A large country facing a multidirectional threat may have to decentralize in order to meet the different challenges it now faces. This is what happened in China after 1850. In contrast, for a small state with limited resources, an increase in the threat level makes centralization and resource pooling more attractive. For a small territory like Japan, the emergence of non-trivial foreign threats renders political decentralization untenable.

We then consider the incentives to modernize. Modernization is costly. It entails social dislocation and creates losers as well as winners, the losers will attempt to block any changes that hurt their interests. We show that for geographically compact polities, it is always a dominant strategy to modernize in the face of a multidirectional threat as the state is able to manage local opposition to reform. This helps to explain why all members of the Japanese political elite came around to favoring rapid modernization by the late 1860s.

Consistent with our model, modernization was more difficult and controversial in China. The Qing government and particularly the Empress Dowager famously opposed the building of railroads. The most well-known example of this was the Wusong Road in Shanghai. Built using foreign investment it was dismantled in 1877 after locals complained about it. The Qing state remained reactive and prepared to kowtow to local powerholders and vested interests rather than confront them. Despite local initiatives, no effort was made at wholesale reforms until after China’s defeat at the hands of Japan in 1895.

koyamaindustrialization
Figure 4: The Wusong Railroad in 1876

* * *

By 1895 it was too late, however. The attempts of the Qing state to reform and modernize led to its collapse. Needless to state, East Asian’s little divergence would have lasting consequences.

Japan’s modernization program astonished foreign observers. Victory over Russia in 1904 propelled Japan to Great Power status but also set Japan on the path to disaster in the World War Two. Nevertheless, the institutional legacy of Japan’s successful late 19th century modernization played a crucial role in Japan’s post-1945 economic miracle.

Following the collapse of the Qing dynasty China fragmented further entering the so-called warlord era (1916–1926). Though the Nationalist regime reunified the country and began a program of modernization, the Japanese invasion and the Second Sino-Japanese War (1937–1945) devastated the country. The end result was that China came to be reunified by the Communist party and to experience more conflict and trauma until it began to embrace market reforms after 1979.